|• FORM 10-Q • SECTION 302 CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER • SECTION 302 CERTIFICATION OF THE CHIEF FINANCIAL OFFICER • CERTIFICATION, SECTION 906, MARK S. THOMPSON • CERTIFICATION, SECTION 906, MARK S. FREY • XBRL INSTANCE DOCUMENT • XBRL TAXONOMY EXTENSION SCHEMA • XBRL TAXONOMY EXTENSION CALCULATION LINKBASE • XBRL TAXONOMY EXTENSION DEFINITION LINKBASE • XBRL TAXONOMY EXTENSION LABEL LINKBASE • XBRL TAXONOMY EXTENSION PRESENTATION LINKBASE|
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the quarterly period ended July 1, 2012
For the transition period from to .
Commission File Number: 001-15181
FAIRCHILD SEMICONDUCTOR INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)
3030 Orchard Parkway
San Jose, California 95134
(Address of principal executive offices, including zip code)
Registrants telephone number, including area code: (408)822-2000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company (as defined in Rule 12b-2 of the Exchange Act).
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares outstanding of each of the issuers classes of common stock as of the close of business on July 1, 2012:
CONSOLIDATED BALANCE SHEETS
See accompanying notes to unaudited consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except per share and percent data)
See accompanying notes to unaudited consolidated financial statements.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying notes to unaudited consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to unaudited consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 Basis of Presentation
The accompanying interim consolidated financial statements of Fairchild Semiconductor International, Inc. (the company) have been prepared in conformity with accounting principles generally accepted in the United States of America, consistent in all material respects with those applied in the companys Annual Report on Form 10-K for the year ended December 25, 2011. The interim financial information is unaudited, but reflects all normal adjustments, which are, in the opinion of management, necessary to provide a fair statement of results for the interim periods presented. The financial statements should be read in conjunction with the financial statements in the companys Annual Report on Form 10-K for the year ended December 25, 2011. Certain amounts for prior periods have been reclassified to conform to the current presentation. The results for the interim periods are not necessarily indicative of the results of operations that may be expected for the full year. The companys fiscal calendar, in which each quarter ends on a Sunday, contains 53 weeks every seven years. This additional week is included in the first quarter of the year. The companys results for the six months ended July 1, 2012 and June 26, 2011 consists of 27 weeks and 26 weeks, respectively.
The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories, goodwill, investments, intangible assets, and other long-lived assets, legal contingencies, and assumptions used in the calculation of income taxes and customer incentives, among others. These estimates and assumptions are based on managements best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. The company adjusts such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, volatile equity and foreign currency markets, and declines in consumer spending have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.
Note 2 Financial Statement Details
Prior to December 26, 2011, the company depreciated much of its machinery and equipment over an eight-year period. During the first quarter of 2012, the company completed an analysis of the useful life assumptions. In performing this analysis, the company examined the historical usage patterns for machinery and equipment at its wafer fabrication and assembly and test manufacturing facilities. As a result of this analysis, the company determined that, while the useful life of its assembly and test equipment was consistent with the eight year depreciation schedule, the wafer fabrication equipment remained in use beyond the eight-year life assigned to that asset category. The typical life was approximately ten years. At the time the analysis was performed, the company was unaware of any events which would result in a change from this historical pattern. Accordingly, the company determined that it would adjust the estimated useful life assumptions for machinery and equipment at the companys wafer fabrication facilities from eight years to ten years to better align its depreciation expense with its actual historical experience. As a result, the company realized a reduction in its depreciation expense of approximately $4.8 million and $9.5 million in the second quarter and first six months of 2012, respectively, when compared to depreciation expense under the previous useful life policy.
In addition, the company reassessed the useful lives, which ranged from one to five years, of its molds and tooling equipment in the first quarter. The historical patterns of molds and tooling usage at its assembly and test manufacturing facilities were examined. Based upon the analysis, it was determined three years was the most appropriate life for these assets. This resulted in a net increase to depreciation expense of $0.7 million in the first quarter of 2012. Impacts on the second quarter were immaterial.
The impact of these change in estimates increased net income by $3.8 million or $0.03 per share in the quarter ended July 1, 2012 and by $8.1 million or $0.06 per share for the six months ended July 1, 2012.
Note 3 Computation of Net Income per Share
Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common shares outstanding during the period, plus the dilutive effect of potential future issuances of common stock relating to potentially dilutive securities. There is no dilution when a net loss exists. Potentially dilutive common equivalent securities consist of stock options, performance units (PUs), deferred stock units (DSUs) and restricted stock units (RSUs). In calculating diluted earnings per share, the dilutive effect of stock options is computed using the average market price for the respective period using the treasury share method. Certain potential shares of the companys outstanding stock options were excluded because they were anti-dilutive, but could be dilutive in the future. The following table sets forth the computation of basic and diluted earnings per share.
Note 4 Supplemental Cash Flow Information
Note 5 Fair Value
Fair Value of Financial Instruments. In accordance with the requirements of the Fair Value Measurements and Disclosures Topic of the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC), the company groups its financial assets and liabilities measured at fair value on a recurring basis in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
In accordance with the requirements of the Fair Value Measurements and Disclosures Topic of the FASB ASC, it is the companys policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. When available, the company uses quoted market prices to measure fair value. If market prices are not available, the fair value measurement is based on models that use primarily market based parameters including interest rate yield curves, option volatilities and currency rates. In certain cases where market rate assumptions are not available, the company is required to make judgments about assumptions market participants would use to estimate the fair value of a financial instrument. Changes in the underlying assumptions used, including discount rates and estimates of future cash flows could significantly affect the results of current or future values. The results may not be realized in an actual sale or immediate settlement of an asset or liability.
The assets and liabilities measured at fair value on a recurring basis include securities and derivatives. Financial instruments classified as Level 1 are securities traded on an active exchange as well as U.S. Treasury, and other U.S. government and agency-backed securities that are traded by dealers or brokers in active over-the-counter markets. Derivatives are classified as Level 2 financial instruments. Auction rate securities are classified as Level 3 financial instruments.
The fair value of securities is based on quoted market prices at the date of measurement, except for auction rate securities. The auction rate security market is no longer active and as a result there is no observable market data for these assets. Fair value estimates are based on judgments regarding current economic conditions, liquidity discounts and interest rate risks. These estimates involve significant uncertainties and judgments and cannot be determined with precision. As a result such calculated fair value estimates may not be realizable in a current sale or immediate settlement of the instrument. In addition, changes in the underlying assumptions used in the fair value measurement technique, including discount rates, liquidity risks and estimates of future cash flows could significantly affect these fair value estimates.
A discounted cash flow (DCF) calculation is performed to determine the estimated fair value of the auction rate securities. The assumptions used in preparing the DCF model included estimates for the amount and timing of future interest and principal payments and the rate of return required by investors to own these securities in the current environment. In making these assumptions, relevant factors that were considered included: the formula applicable to each security which defines the interest rate paid to investors in the event of a failed auction; forward projections of the interest rate benchmarks specified in such formulas; the likely timing of principal repayments; the probability of full repayment considering guarantees by third parties and additional credit enhancements provided through other means. The estimate of the rate of return required by investors to own these securities also considers the current reduced liquidity for auction rate securities. Inputs for DCF calculations are based upon publicly available data as well as the companys own estimates. The primary unobservable input to the valuation was the maturity assumption which ranged from twenty one to thirty three years for 2012 valuations and from four to ten years for 2011 valuations. Current maturity assumptions are at the contractual maturity. Any significant decreases in the maturity assumptions may result in higher fair values. The maturity assumptions are dependent on the individual auction rate security. The maturity assumptions were based on the terms of the underlying instrument and the potential for restructuring the auction rate security.
All of the companys derivatives are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the company measures fair value using prices obtained from the counterparties with whom the company has traded. The counterparties price the derivatives based on models that use primarily market observable inputs, such as yield curves and option volatilities. Accordingly, the company classifies these derivatives as Level 2.
The company is exposed to credit-related losses in the event of non-performance by counterparties to hedging instruments. The counterparties to all derivative transactions are major financial institutions. However, this does not
eliminate the companys exposure to credit risk with these institutions. This credit risk is generally limited to the unrealized gains in such contracts should any of these counterparties fail to perform as contracted. The company considers the risk of counterparty default to be minimal.
The following table presents the balances of assets and liabilities measured at fair value on a recurring basis as of July 1, 2012.
The following table summarizes the changes in level 3 securities measured at fair value on a recurring basis for the six months ended July 1, 2012.
Long term debt is carried at amortized cost. However, the company is required to estimate the fair value of long term debt under the Financial Instrument Topic of the FASB ASC. The carrying amount of the revolving facility is considered to approximate fair value as the interest rate on the loan is similar to current market rates. See Note 12 for more information on the credit facility.
Note 6 Derivatives
Derivatives. The company uses derivative instruments to manage exposures to changes in foreign currency exchange rates. In accordance with the requirements of the Derivatives and Hedging Topic of the FASB ASC, the fair value of these hedges is recorded on the balance sheet. For the fair value of derivatives, see Note 5.
Foreign Currency Derivatives. The company uses currency forward and combination option contracts to hedge a portion of its forecasted foreign exchange denominated revenues and expenses. The company monitors its foreign currency exposures to maximize the overall effectiveness of its foreign currency hedge positions. Currencies hedged include the euro, Japanese yen, Philippine peso, Malaysian ringgit, Korean won and Chinese yuan. The companys objectives for holding derivatives are to minimize the risks using the most effective methods to eliminate or reduce the impacts of these exposures. The maturities of the cash flow hedges are 21 months or less.
Changes in the fair value of derivative instruments related to time value are included in the assessment of hedge effectiveness. Hedge ineffectiveness, determined in accordance the Derivatives and Hedging Topic of the FASB ASC, did not have a material impact on earnings for the three and six months ended July 1, 2012. No cash flow hedges were derecognized or discontinued during the three and six months ended July 1, 2012.
Derivative gains and losses included in accumulated other comprehensive income (AOCI) are reclassified into earnings at the time the forecasted transaction is recognized. The company estimates that $2.0 million of net unrealized derivative losses included in AOCI will be reclassified into earnings within the next twelve months.
The company also uses currency forward and combination option contracts to offset the foreign currency impact of balance sheet translation. These derivatives have one month terms and the initial fair value, if any, and the subsequent gains or losses on the change in fair value are reported in earnings within the same income statement line as the impact of the foreign currency translation. From time to time, the company will also hedge the liability for an expected cash payment in foreign currency. These derivatives have terms that match the expected payment timing. The initial fair value, if any, and the subsequent gains or losses on the change in fair value are reported in earnings within the same income statement line as the change in value of the liability due to changes in currency value.
The tables below show the notional principal and the location and amounts of the derivative fair values in the consolidated balance sheet as of July 1, 2012 and December 25, 2011 as well as the location of derivative gains and losses in the statement of operations for the six months ended July 1, 2012 and June 26, 2011. Pursuant to the Derivatives and Hedging Topic of the FASB ASC, the company nets the fair value of all derivative financial instruments with counterparties for which a master netting arrangement is utilized. The notional principal amounts for these instruments provide one measure of the transaction volume outstanding as of the end of the period and do not represent the amount of the companys exposure to credit or market loss. The estimates of fair value are based on applicable and commonly used pricing models using prevailing financial market information as of July 1, 2012 and December 25, 2011. Although the following table reflects the notional principal and fair value of amounts of derivative financial instruments, it does not reflect the gains or losses associated with the exposures and transactions that these financial instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures will depend on actual market conditions during the remaining life of the instruments.
The following tables present derivatives designated as hedging instruments under the Derivatives and Hedging Topic of the FASB ASC.
The following tables present derivatives not designated as hedging instruments under Derivatives and Hedging Topic of the FASB ASC.
Note 7 Securities
The company invests excess cash in marketable securities consisting primarily of money markets, commercial paper, corporate notes and bonds, and U.S. government securities. While the company still holds auction rate securities, the company no longer actively invests in them.
All of the companys securities are classified as available-for-sale. In accordance with the Investments Debt and Equity Securities Topic of the FASB ASC, available-for-sale securities are carried at fair value with unrealized gains and losses included as a component of AOCI within stockholders equity, net of any related tax effect, if such gains and losses are considered temporary. Realized gains and losses on these investments are included in interest income and expense. Declines in value judged by management to be other-than-temporary and credit related are included in impairment of investments in the statement of operations. The noncredit component of impairment is included in AOCI. For the purpose of computing realized gains and losses, cost is identified on a specific identification basis. There were no material realized gains or losses on sales of securities in the first six months of 2012 or 2011. Proceeds from the sales of securities in the second quarter of 2012 were $0.3 million. There were no sales of securities in 2011.
Securities are summarized as of July 1, 2012:
In aggregate, the auction rate securities have been in an unrealized loss position for over a year. The continued unrealized loss is attributable to the ongoing volatility in the global equities markets and uncertainty in the credit markets primarily from the European debt situation and other global economic uncertainty. However, the company does not intend to sell or believe it is more likely than not that the company would be required to sell the securities before a recovery of the amortized cost basis of the investment. In addition, as a result of the continued performance of the issue and its insurance guarantee, the company considers this decrease in fair value to be temporary in nature.
Securities are summarized as of December 25, 2011:
The following table presents the amortized cost and estimated fair market value of available-for-sale securities by contractual maturity as of July 1, 2012.
As of July 1, 2012, auction rate securities with a market value of $26.0 million are included in the table above in contractual maturities due after ten years. The companys auction rate securities are composed of approximately $17.6 million of securities that are structured obligations of special purpose reinsurance entities associated with life insurance companies and $8.4 million of corporate debt securities issued by a special purpose financial services corporation that offers credit risk protection through writing credit derivatives. The company continues to accrue and receive interest on these securities based on a contractual rate.
The following table presents a roll forward of the amount related to credit losses recognized in earnings during the six months ended July 1, 2012.
There is no portion of other-than-temporary impairment related to credit loss currently included in AOCI.
Note 8 Segment Information
Fairchild is currently organized onto three reporting segments. The organization is an application based structure which corresponds with the way the company manages the business. The majority of the companys activities are aligned into two focus areas; MCCC, which focuses on mobile and ultraportable products and PCIA, which focuses on power supply and motor control solutions. Each of these segments has a specific focus area, a small set of leading customers, and common technology requirements for their product groups. The third reporting segment, SDT, combines the management of multiple market products that provide generic solutions for standard diodes / transistors, standard linear, and infrared.
Effective the first day of 2012, the mature logic group was transferred from the MCCC reporting segment to SDT and the management of the ground fault interrupt (GFI) products was moved from MCCC to PCIA. Prior year numbers have been restated to reflect this change.
The following table presents selected operating segment financial information for the three and six months ended July 1, 2012 and June 26, 2011.
PCIA revenue for the three and six months ended July 1, 2012 includes $4.0 million of insurance proceeds related to business interruption claims for the companys optoelectronics supply issues resulting from the Thailand floods in the fourth quarter of 2011.
Other in 2011 primarily consists of accelerated depreciation related to the previously planned closure of the Mountaintop facility.
Note 9 Goodwill and Intangible Assets
The following table presents a summary of acquired intangible assets.
The following table presents the carrying value of goodwill by reporting unit.
During the first quarter of 2012, the company moved two small product groups from the MCCC organization. Since this changed the companys reporting units, goodwill was assigned to the reporting units affected using a relative fair value allocation. See footnote 8 for more information.
The following table presents the estimated amortization expense for intangible assets for the remainder of 2012 and for each of the five succeeding fiscal years.
Note 10 Restructuring and Impairments
During the three and six months ended July 1, 2012, the company recorded restructuring and impairment charges, net of releases, of $0.5 million and $2.9 million, respectively. The detail of these charges is presented in the summary table below.
During the three and six months ended June 26, 2011, the company recorded restructuring and impairment charges, net of releases, of $2.9 million and $5.4 million, respectively. The second quarter charges include $0.5 million of employee separation costs, $0.3 million of fab closure costs, and $0.1 million of reserve releases associated with the 2009 Infrastructure Realignment Program as well as $0.9 million in employee separation costs associated with the 2010 Infrastructure Realignment Program and $1.3 million in employee separation costs associated with the 2011 Infrastructure Realignment Program. First quarter charges include $0.6 million of employee separation costs and $0.2 million of fab closure costs associated with the 2009 Infrastructure Realignment Program as well as $1.0 million in employee separation costs associated with the 2010 Infrastructure Realignment Program and $0.7 million in employee separation costs associated with the 2011 Infrastructure Realignment Program.
The 2012 Infrastructure Realignment Program includes costs for organization changes in the companys sales organization, manufacturing sites and manufacturing support organizations, the MCCC and PCIA product lines as well as the final closure of a warehouse in Korea. The 2011 Infrastructure Realignment Program includes costs for organizational changes in the companys supply chain management group, the website technology group, the quality organization, and other administrative groups. The 2011 program also includes costs to further improve the companys manufacturing strategy and changes in the PCIA and MCCC groups as well as a primarily voluntary retirement program at our Mountaintop, Pennsylvania location. The 2010 Infrastructure Realignment Program includes costs to simplify and realign some activities within the MCCC segment, costs for the continued refinement of the companys manufacturing strategy, and costs associated with centralizing the companys accounting functions. The 2009 Infrastructure Realignment Program included costs associated with the previously planned closure of the Mountaintop, Pennsylvania manufacturing facility and the four-inch manufacturing line in Bucheon, South Korea, both of which were announced in the first quarter of 2009. The 2009 Program also included charges for a smaller worldwide cost reduction plan to further right-size our company. The consolidation of the South Korea fabrication lines was completed in 2011. Also during 2011, the company decided to keep open the Mountain Top facility reversing the March 2009 announcement to close the site.
The following table presents a summary of the activity in the companys accrual for restructuring and impairment costs for the quarterly periods ended April 1, 2012 and July 1, 2012.
Note 11 Contingencies
Patent Litigation with Power Integrations, Inc. There are four outstanding proceedings with Power Integrations.
POWI 1: On October 20, 2004, the company and our wholly owned subsidiary, Fairchild Semiconductor Corporation, were sued by Power Integrations, Inc. in the U.S. District Court for the District of Delaware. Power Integrations alleged that certain of the companys pulse width modulation (PWM) integrated circuit products infringed four Power Integrations U.S. patents, and sought a permanent injunction preventing the company from manufacturing, selling or offering the products for sale in the U.S., or from importing the products into the U.S., as well as money damages for past infringement.
The trial in the case was divided into three phases. In the first phase of the trial that occurred in October of 2006, a jury returned a verdict finding that thirty-three of the companys PWM products willfully infringed one or more of seven claims asserted in the four patents and assessed damages against the company. The company voluntarily stopped U.S. sales and importation of those products in 2007 and has been offering replacement products since 2006. Subsequent phases of the trial conducted during 2007 and 2008 focused on the validity and enforceability of the patents. In December of 2008, the judge overseeing the case reduced the jurys 2006 damages award from $34 million to approximately $6.1 million and ordered a new trial on the issue of willfulness. Following the new trial held in June of 2009, the court found the companys infringement to have been willful and in January 2011 the court awarded Power Integrations final damages in the amount of $12.2 million. We have challenged the final damages award, willfulness finding, and other issues on appeal. Power Integrations also appealed aspects of the trial courts ruling, including damages. On January 11, 2012, the appeals were argued before the U.S. Court of Appeals for the Federal Circuit. The company expects a ruling prior to the end of 2012.
POWI 2: On May 23, 2008, Power Integrations filed another lawsuit against the company, Fairchild Semiconductor Corporation and our wholly owned subsidiary System General Corporation in the U.S. District Court for the District of Delaware, alleging infringement of three patents. Of the three patents claimed in that lawsuit, two were asserted against the company and Fairchild Semiconductor Corporation in the October 2004 lawsuit described above. In 2011, POWI added a fourth patent to this case.
On October 14, 2008, Fairchild Semiconductor Corporation and System General Corporation filed a patent infringement lawsuit against Power Integrations in the U.S. District Court for the District of Delaware, alleging that certain PWM integrated circuit products infringe one or more claims of two U.S. patents owned by System General. The lawsuit seeks monetary damages and an injunction preventing the manufacture, use, sale, offer for sale or importation of Power Integrations products found to infringe the asserted patents.
Both lawsuits were consolidated and heard together in Delaware District Court in a jury trial in April of 2012. On April 27, 2012, the jury found that Power Integrations infringed one of the two U.S. patents owned by System General and upheld the validity of both System General patents. In the same case, the jury found that the company infringed two of four U.S. patents asserted by Power Integrations and that the company had induced its customers to infringe the asserted patents. The jury also upheld the validity of the asserted Power Integrations patents. The verdict concluded the first phase of trial in the litigation. Willfulness and damages in the case will be determined in a second phase, which has yet to be scheduled and may occur after appeals of the first phase.
POWI 3: On November 4, 2009, Power Integrations, Inc. filed a complaint for patent infringement against the company and two of the companys subsidiaries in the United States District Court for the Northern District of California alleging that several of our products infringe three of Power Integrations patents. One of those patents has since been dropped from the case. The company intends to put on a vigorous defense against these claims. In the same lawsuit we have filed counterclaims against Power Integrations, alleging Power Integrations products infringe certain claims of one of our patents. Trial has yet to be scheduled in this case.
POWI 4: On February 10, 2010 Fairchild and System General filed a lawsuit in Suzhou, China against four Power Integrations entities and seven vendors. The lawsuit claims that Power Integrations violates certain Fairchild/System General patents. Fairchild is seeking an injunction against the Power Integrations products and over $17.0 million in damages. Power Integrations attempted to have the Fairchild/System General patents declared invalid in proceedings before the Chinese Patent Office. Based on the Patent Offices ruling, three of the four patents asserted by Fairchild will continue in the case.
Hearings comparable to a trial in U.S. litigation were held in January, May and July 2012, And the company anticipates that the court will rule on the case before the end of 2012.
POWI 5: On May 1, 2012, Fairchild sued Power Integrations in United States District Court for the District of Delaware. The lawsuit accuses Power Integrations LinkSwitch-PH LED power conversion products of violating three Fairchild patents. Power Integrations has counterclaimed against Fairchild asserting five Power Integrations patents but has not specified any Fairchild products to date.
Other Legal Claims. From time to time the company is involved in legal proceedings in the ordinary course of business. The company believes that there is no such ordinary-course litigation pending that could have, individually or in the aggregate, a material adverse effect on our business, financial condition, results of operations, or cash flows. Legal costs are expensed as incurred.
The company analyzes potential outcomes from current litigation in accordance with the Contingency Topic of the FASB ASC. Accordingly, the company analyzes such outcomes as loss contingencies, and divides them into three categories based on the possibility that the contingency will give rise to an actual loss. The first category represents contingencies for which management believes the possibility of loss is remote. For contingencies in this category, the company does not record a reserve or assess the range of possible losses. The second category represents contingencies for which losses are believed to be reasonably possible. For this category, the company assesses the range of possible losses but does not record a reserve. There are currently no contingencies in this category. The third category represents contingencies for which losses are believed to be probable. For this category, the company determines the range of losses and records a reserve reflecting the best estimate within the range. For contingencies within this category, the company currently believes the range of probable losses are approximately $14.0 million to $15.0 million and the best estimate of losses within this range to be $14.1 million as of July 1, 2012 and has recorded this amount as a reserve. The amount reserved is based upon assessments of the potential liabilities using analysis of claims and historical experience in defending and resolving such claims.
Note 12 Long-Term Debt
Long-term debt consists of the following at:
Note 13 Subsequent Events
The company has evaluated subsequent events and did not identify any events that required disclosure.
Except as otherwise indicated in this Quarterly Report on Form 10-Q, the terms we, our, the company, Fairchild and Fairchild International refer to Fairchild Semiconductor International, Inc. and its consolidated subsidiaries, including Fairchild Semiconductor Corporation, our principal operating subsidiary. We refer to individual subsidiaries where appropriate.
In 2012, we believe Fairchild is positioned to capitalize on the growth potential in mobile wireless technologies and the transition to more efficient applications in the industrial, appliance, automotive and solar end markets. We have invested heavily in our mobile business over the last five years and have introduced a wide range of fast growing new products and a number of innovative application specific solutions that solve unique customer requirements. We believe our broad portfolio of innovative products coupled with our world class supply chain will continue to drive growth. We entered 2012 with the best pipeline of new products in our history. We have numerous design wins in our mobile business and we are also gaining traction in the mid-voltage market.
We strive to keep inventory as lean as possible while maintaining customer service. We prefer to maintain maximum flexibility by adjusting internal inventories in response to higher demand before adding more inventory to our distribution channels. While our goal is to manage our production output to maintain channel inventories within a target range of 7.5 to 8.5 weeks, at the end of the second quarter, our channel inventories were more than 10 weeks, which was a decrease of over one week from the end of 2011. Internal inventories at the end of the second quarter of 2012 were at $239.7 million, an increase of $5.5 million over the end of 2011.
Our fiscal calendar, in which each quarter ends on a Sunday, contains 53 weeks every seven years. This additional week is included in the first quarter of the year. Our results for the six months ended July 1, 2012 and June 26, 2011 consist of 27 weeks and 26 weeks, respectively.
The Mobile, Computing, Consumer and Communication (MCCC) groups main focus is to supply the mobile, computing, consumer and communication end market segments with innovative power and signal path solutions including our low voltage metal oxide semiconductor field effect transistors (MOSFETs), Power Management integrated circuits (ICs), Mixed Signal Analog and Logic products. We seek to deliver exceptional product performance by optimizing silicon processes and application specific design to satisfy specific requirements for our customers. This enables us to deliver solutions with greater energy efficiency and in a smaller footprint than is commonly available. We expect a steady acceleration of new product sales especially for solutions addressing the handset and ultraportable market.
The Power Conversion, Industrial, and Automotive (PCIA) groups focus is to capitalize on the growing demand for greater energy efficiency and higher power density for space savings in power supplies, consumer electronics, battery chargers, electric motors, industrial electronics and automobiles. We are a leader in power semiconductor devices, low standby power consumption designs, and power module technology that enable greater efficiency, greater power density, and better performance. Improving the efficiency of our customers products is vital to meeting new energy efficiency regulations. Effectively managing the power conversion and distribution in power supplies is one of the greatest opportunities we have to improve overall system efficiency. We believe the growing global focus on energy efficiency will continue to drive growth in this product line.
Standard Discrete and Standard Linear (SDT) products are core building block components for many electronic applications. This segment is moving to a more simplified and focused operating model to make the selling and support of these products easier and more profitable. The right operational structure and part portfolio should enable our standard products group to continue to generate solid cash flow with minimal investment.
Results of Operations
The following table summarizes certain information relating to our operating results as derived from our unaudited consolidated financial statements.
Adjusted net income, adjusted gross margin, and free cash flow are also included in the table below. These are non-GAAP financial measures and should not be considered a replacement for GAAP results. We present adjusted results because we use them as additional measures of our operating performance. We believe the adjusted information is useful to investors because it illuminates underlying operational trends by excluding certain significant non-recurring or otherwise unusual transactions. Our criteria for adjusted results may differ from methods used by other companies and may not be comparable and should not be considered as alternatives to net income or loss, gross margin, or other measures of consolidated operations and cash flow data prepared in accordance with US GAAP as indicators of our operating performance or as alternatives to cash flow as a measure of liquidity.
Revenue in the second quarter of 2012 included $4.0 million of insurance proceeds related to business interruption claims for the companys optoelectronics supply issues resulting from the Thailand floods in the fourth quarter of 2011. Despite an extra week in the first six months of 2012 compared to the first six months of 2011 revenue decreased in 2012. Lower unit sales volume sold drove 9% of the decrease in revenue in the second quarter and first six months of 2012 when compared to the same periods in 2011. The remaining 7% decline in revenue was caused by lower average selling prices.
Geographic revenue information is based on the customer location within the indicated geographic region. The following table presents, as a percentage of sales, geographic sales for the U.S., Other Americas, Europe, China, Taiwan, Korea and
Other Asia/Pacific (which for our geographic reporting purposes includes Japan and Singapore) for the three months and six months ended July 1, 2012. The increase in Other Asia/Pacific revenue was due to continued strong demand for mobile products including smart phones and tablets as well as a shift in sales from a major customer from Korea to Other Asia/Pacific.
Effective the first day of 2012, expected asset lives and amortization schedules for certain factory equipment was adjusted to better reflect actual performance of the tools, favorably impacting gross margin by approximately $4.8 million and $9.5 million in the second quarter and first six months of 2012, respectively, when compared to depreciation expense under the previous useful life policy. In addition, we reassessed the lives of our molds and tooling equipment which caused an increase in depreciation expense of $0.7 million in first six months of 2012 when compared to depreciation expense under the previous useful life policies.
The net favorable depreciation impact to gross margin was offset by decreased revenue, increased expenses from 8-inch conversion costs, higher inventory write downs, as well as higher unit costs of inventory due to lower production rates resulting in an overall decrease in gross margin for the second quarter and first six months of 2012 as compared to the same periods in 2011.
Adjusted Gross Margin
There were no items adjusted out of gross margin in the second quarter and first six months of 2012. Adjusted gross margin in the second quarter and first six months of 2011 did not include accelerated depreciation related to the previously planned closure of the Mountain Top facility. See above reconciliation for detail.
Operating expenses included an additional week of costs in the first six months of 2012 as compared to the first six months of 2011. Research and development (R&D) expenses increased for the second quarter and first six months of 2012 as compared to the same periods in 2011 as we continue to invest in R&D programs and resources. Increased R&D project spending was offset in part by decreases in variable compensation expense. Selling and general and administration expenses (SG&A) expense decreased slightly for the second quarter and first six months of 2012 when compared to the same periods of 2011 driven primarily by a decrease in variable compensation.
Restructuring and Impairment. During the three and six months ended July 1, 2012, we recorded restructuring and impairment charges, net of releases, of $0.5 million and $2.9 million, respectively. The second quarter charges consist of $0.6 million of employee separation costs associated with the 2012 Infrastructure Realignment Program and $0.1 reserve release associated with the 2011 Infrastructure Realignment Program. The first quarter charges include $1.0 million of employee separation costs associated with the 2011 Infrastructure Realignment Program as well as $1.1 million in employee separation costs and $0.4 million in facility closure costs associated with the 2012 Infrastructure Realignment Program.
During the three and six months ended June 26, 2011, we recorded restructuring and impairment charges, net of releases, of $2.9 million and $5.4 million, respectively. The second quarter charges include $0.5 million of employee separation costs, $0.3 million of fab closure costs, and $0.1 million of reserve releases associated with the 2009 Infrastructure Realignment Program as well as $0.9 million in employee separation costs associated with the 2010 Infrastructure Realignment Program and $1.3 million in employee separation costs associated with the 2011 Infrastructure Realignment Program. First quarter charges include $0.6 million of employee separation costs and $0.2 million of fab closure costs associated with the 2009 Infrastructure Realignment Program as well as $1.0 million in employee separation costs associated with the 2010 Infrastructure Realignment Program and $0.7 million in employee separations costs associated with the 2011 Infrastructure Realignment Program.
The 2012 Infrastructure Realignment Program includes costs for organization changes in the companys sales organization, manufacturing sites and manufacturing support organizations, the MCCC and PCIA product lines as well as the final closure of a warehouse in Korea. The 2011 Infrastructure Realignment Program includes costs for organizational changes in our supply chain management group, website technology group, quality organization, and other administrative groups. The 2011 program also includes costs to further improve our manufacturing strategy and changes in both the PCIA and MCCC groups as well as a primarily voluntary retirement program at our Mountaintop, Pennsylvania location. The 2010 Infrastructure Realignment Program includes costs to simplify and realign some activities within the MCCC segment, costs for the continued refinement of the companys manufacturing strategy, and costs associated with centralizing our accounting functions.
The previously planned closure of the Mountaintop, Pennsylvania manufacturing facility and the closure of the four-inch manufacturing line in Bucheon, South Korea was announced in the first quarter of 2009 and the charges associated with those programs are included in the 2009 Infrastructure Realignment Program. The consolidation of the South Korea fabrication lines was completed in 2011. Also during the fourth quarter of 2011, the company decided to keep open the Mountain Top facility.
Charge for Litigation. In the second quarter of 2012, we increased our reserves for potential litigation outcomes by $1.0 million as a result of the ongoing developments in the POWI 2 litigation. In addition, we accrued $0.3 million for an unrelated legal settlement.
Other Expense, net.
The following table presents a summary of other expense, net for the three months and six months ended July 1, 2011 and June 26, 2011.
Interest expense. Interest expense in the second quarter and first six months of 2012 increased $0.2 million and $0.6 million, respectively, when compared to the same period in 2011, primarily due to higher interest rates offset by higher debt in the first quarter of 2011.
Interest income. Interest income in second quarter and first six months of 2012 remained fairly flat when compared to the same periods in 2011.
Other (income) expense, net. Other expense in the second quarter and first six months of 2012 was down $2.1 million for both the second quarter and the first six months of 2012 when compared to the same periods of 2011. The higher level of expense in 2011 was caused by a $2.1 million write off of deferred financing fees associated with the pay down of our term loan in the second quarter of 2011.
Income Taxes. Income tax provision in the second quarter and first six months of 2012 was $1.9 million and $1.7 million on income before taxes of $13.8 million and $15.1 million, respectively, as compared to income tax provisions of $6.7 million and $14.0 million on income before taxes of $51.6 million and $102.4 million, respectively, for the same periods of 2011. The effective tax rate for the second quarter and first six months of 2012 was 14.0% and 11.2% compared to 13.0% and 13.7%, respectively, for the comparable periods of 2011. The change in effective tax rate is primarily due to shifts of income and loss among jurisdictions with differing tax rates. In the first six months of 2012, the valuation allowance on our deferred tax assets decreased by $2.9 million. The overall decrease did not impact our results of operations.
In accordance with the Income Taxes Topic in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC), deferred taxes have not been provided on undistributed earnings of foreign subsidiaries which are reinvested indefinitely. Certain non-U.S. earnings, which have been taxed in the U.S. but earned offshore, have and continue to be part of our repatriation plan. As of July 1, 2012, we have recorded a deferred tax liability of $1.8 million, with no impact to the consolidated statement of operations as we have a full valuation allowance against our net U.S. deferred tax assets.
Free Cash Flow
Free cash flow is a non-GAAP financial measure. To determine free cash flow, we subtract capital expenditures from cash provided by operating activities. Free Cash flow decreased in the second quarter and first six months of 2012 as compared to the same periods in 2011 as a result of lower net income offset in part by a decrease in capital expenditures. See Free Cash Flow reconciliation in results of operations section above.
The following tables present comparative disclosures of revenue, gross margin, and operating income of our reportable segments.
MCCC revenue in the second quarter and first six months of 2012 was relatively flat as compared to the same periods of 2011 due to continued strong sales of our mobile switch products offset by reduced sales of our low voltage MOSFET products. Overall average selling prices in the second quarter of 2012 were also relatively flat as compared to the same period in 2011 but were slightly lower in the first six months of 2012 as compared to the same periods in 2011 as pricing pressure for our low voltage products were offset by the introduction of new mobile products. Gross margin improvement in the second quarter of 2012 was higher when compared to the second quarter of 2011 as a result of continued mix shift toward mobile products that yield better margins. Slightly lower gross margins in the first six months of 2012 were driven by higher unit costs of inventory sold in the first quarter from lower production rates in the fourth quarter of 2011.
MCCC operating income increased in the second quarter of 2012 as compared to 2011 as a result of higher gross margin and reduced variable compensation expense offset by additional R&D investment in our mobile and MEMs businesses. Operating income decreased in the first six months of 2012 compared to 2011 as a result of lower gross margin, higher R&D investment, and an additional week of costs in the first six months of 2012 as compared to 2011; offset largely by reduced variable compensation.
PCIA revenue in the second quarter of 2012 included $4.0 million of insurance proceeds related to business interruption claims for the companys optoelectronics supply issues resulting from flooding in Thailand in the fourth quarter of 2011. The revenue decrease in the second quarter and first six months of 2012 as compared to the same periods of 2011 was primarily attributable to reduced market demand for our high voltage products and efforts to manage channel inventory. The decreased revenue from high voltage products was mitigated in part by strong sales for our automotive products, particularly advanced power management products. Lower gross margin was mainly a result of decreased revenue and increased 8 inch conversion costs.
Lower operating income was mainly due to decreased gross margin as well as increased R&D expense. In addition, operating expenses included an additional week of costs in the first six months of 2012 as compared to 2011. These increases were offset in part by lower selling, general and administrative expenses (SG&A) and reduced variable compensation expenses.
The SDT revenue decrease in the second quarter and first six months of 2012 as compared to the same periods in 2011 was from our strategic efforts to eliminate lower margin products and also reduced overall market demand. Lower average selling prices also contributed to the decrease in SDT revenue as compared to the second quarter and first six months of 2011. Lower gross margin was due to lower revenue and higher overhead costs.
The decrease in operating income was primarily due to lower gross margin. R&D and sales and marketing expenses were also higher in the second quarter and first six months of 2012 as a result of increased investment in R&D and sales and marketing. In addition operating expenses included an additional week of costs in the first six months of 2012 as compared to 2011. This increase was offset in part by reduced variable compensation costs.
Liquidity and Capital Resources
Our main sources of liquidity are our cash flows from operations, cash and cash equivalents and our revolving credit facility. As of July 1, 2012, $226.1 million of our $431.0 million cash and marketable securities balance is located in the United States. We believe that funds generated from operations, together with existing cash and funds from our revolving credit facility will be sufficient to meet our cash needs over the next twelve months.
Our Credit Facility consists of a $400.0 million revolving loan agreement of which $300 million was drawn as of July 1, 2012. After adjusting for outstanding letters of credit, we had $98.7 million available under the Credit Facility. This revolving borrowing capacity is available for working capital and general corporate purposes, including acquisitions. We had additional outstanding letters of credit of $1.9 million that do not fall under the senior credit facility. We also had $0.6 million of undrawn credit facilities at certain of our foreign subsidiaries. These outstanding amounts do not impact available borrowings under the senior credit facility.
The Credit Facility includes restrictive covenants that place limitations on our ability to consolidate, merge, or enter into acquisitions, create liens or pay dividends, or make similar restricted payments, sell assets, invest in capital expenditures, and incur indebtedness. It also places limitations on our ability to modify our certificate of incorporation and bylaws, or enter into shareholder agreements, voting trusts or similar arrangements. In addition, the affirmative covenants in the Credit Facility also require our financial performance to comply with certain financial measures, as defined by the credit agreement. These financial covenants require us to maintain a minimum interest coverage ratio of 3.0 to 1.0 and a maximum leverage ratio of 3.25 to 1.0. It defines the interest coverage ratio as the ratio of the cumulative four quarter trailing consolidated earnings before interest, taxes, depreciation and amortization (EBITDA) to consolidated cash interest expense and defines the maximum leverage ratio as the ratio of total consolidated debt to the cumulative four quarter trailing consolidated EBITDA. Consolidated EBITDA, as defined by the credit agreement excludes restructuring, non-cash equity compensation and other certain adjustments.
At July 1, 2012, we were in compliance with these covenants and we expect to remain in compliance with the covenants. This expectation is subject to various risks and uncertainties discussed more thoroughly in Item 1A, and include, among others, the risk that our assumptions and expectations about business conditions, expenses and cash flows for the remainder of the year may be inaccurate.
While our senior credit facility places restrictions on the payment of dividends, it does not restrict the subsidiaries of Fairchild Semiconductor Corporation, except to a limited extent, from paying dividends or making advances to Fairchild Semiconductor Corporation. As a result, we believe that funds generated from operations, together with existing cash and funds from our senior credit facility will be sufficient to meet our debt obligations, operating requirements, capital expenditures and research and development funding needs over the next twelve months. In the first six months 2012, our capital expenditures totaled $80.1 million.
We frequently evaluate opportunities to sell additional equity or debt securities, obtain credit facilities from lenders or restructure our long-term debt to further strengthen our financial position. The sale of additional equity securities would cause dilution to our existing stockholders. Additional borrowing or equity investment may be required to fund future acquisitions.
During the first six months of 2012, our cash provided by operating activities was $79.5 million compared to $149.8 million in the same period of 2011. The following table presents a summary of net cash provided by operating activities during the first six months of 2012 and 2011.
Cash provided by operating activities decreased $70.3 million during the first six months of 2012 as compared to the same period of 2011 driven primarily by the decrease in net income.
Cash used in investing activities during the first six months of 2012 totaled $81.0 million compared to $105.9 million for the same period of 2011. The higher level of cash used in 2011 was driven by the TranSiC acquisition of $16.5 million. There were no corresponding acquisitions in 2012.
Cash used in financing activities totaled $19.5 million in the first six months of 2012 compared to $12.8 million of cash used in financing activities in the same period of 2011. This difference was driven by 2011 proceeds from the
exercise of stock options offset partially by 2011 debt repayments and the write off of deferred financing fees . In the first six months of 2011 we received $35.2 million in proceeds from the exercise of stock options which were partially offset by a $20.6 million repayment of long term debt and $5.2 million deferred financing fees write-off . In 2012, we had proceeds of $0.6 million from the exercise of stock options and no debt repayments.
For the six months ended July 1, 2012, we recorded no change to the $2.8 million of net unrecognized tax benefits recorded in current taxes payable at December 25, 2011. The timing of the expected cash outflow relating to the balances is expected within one year.
Forward Looking Statements
This quarterly report contains forward-looking statements as that term is defined in Section 21E of the Securities Exchange Act of 1934. Forward-looking statements can be identified by the use of forward-looking terminology such as we believe, we expect, we intend, may, will, should, seeks, approximately, plans, estimates, anticipates, or hopeful, or the negative of those terms or other comparable terms, or by discussions of our strategy, plans or future performance. All forward-looking statements in this report are made based on managements current expectations and estimates, which involve risks and uncertainties, including those described below and more specifically in the Risk Factors section. Among these factors are the following: current economic uncertainty, including disruptions in the credit markets, as well as future economic conditions; changes in demand for our products; changes in inventories at our customers and distributors; changes in regional or global economic or political conditions (including as a result of terrorist attacks and responses to them); technological and product development risks, including the risks of failing to maintain the right to use some technologies or failing to adequately protect our own intellectual property against misappropriation or infringement; availability of manufacturing capacity; the risk of production delays; the inability to attract and retain key management and other employees; risks related to warranty and product liability claims; risks inherent in doing business internationally; changes in tax regulations or the migration of profits from low tax jurisdictions to higher tax jurisdictions; availability and cost of raw materials; competitors actions; loss of key customers, including but not limited to distributors; order cancellations or reduced bookings; changes in manufacturing yields or output; and significant litigation. Factors that may affect our operating results are described in the Risk Factors section in the quarterly and annual reports we file with the Securities and Exchange Commission. Such risks and uncertainties could cause actual results to be materially different from those in the forward-looking statements. Readers are cautioned not to place undue reliance on the forward-looking statements.
Recently Issued Financial Accounting Standards
There were no new standards issued in the first six months of 2012.
Reference is made to Part II, Item 7A, Quantitative and Qualitative Disclosure about Market Risk, in Fairchild Semiconductor Internationals annual report on Form 10-K for the year ended December 25, 2011 and under the subheading Quantitative and Qualitative Disclosures about Market Risk in Managements Discussion and Analysis of Financial Condition and Results of Operations on page 52 of the Form 10-K. There were no material changes in the information we provided in our Form 10-K during the period covered by this Quarterly Report.
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures designed to assure, as much as is reasonably possible, that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended, is communicated to management and recorded, processed, summarized and disclosed within the specified time periods. As of the end of the period covered by this report, our chief executive officer (CEO) and chief financial officer (CFO), with the participation of our management, have evaluated the effectiveness of our disclosure controls and procedures. Based on the evaluation, our CEO and CFO concluded that as of July 1, 2012, our disclosure controls and procedures are effective.
Inherent Limitations on Effectiveness of Controls
The companys management, including the CEO and CFO, does not expect that our disclosure controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control systems objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events. There can be no assurance that any control system will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become less effective if conditions change or compliance with policies or procedures deteriorates.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the first six months of 2012 that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
There are four outstanding proceedings with Power Integrations.
POWI 1: On October 20, 2004, we and our wholly owned subsidiary, Fairchild Semiconductor Corporation, were sued by Power Integrations, Inc. in the U.S. District Court for the District of Delaware. Power Integrations alleged that certain of our pulse width modulation (PWM) integrated circuit products infringed four Power Integrations U.S. patents, and sought a permanent injunction preventing us from manufacturing, selling or offering the products for sale in the U.S., or from importing the products into the U.S., as well as money damages for past infringement.
The trial in the case was divided into three phases. In the first phase of the trial that occurred in October of 2006, a jury returned a verdict finding that thirty-three of our PWM products willfully infringed one or more of seven claims asserted in the four patents and assessed damages against us. We voluntarily stopped U.S. sales and importation of those products in 2007 and have been offering replacement products since 2006. Subsequent phases of the trial conducted during 2007 and 2008 focused on the validity and enforceability of the patents. In December of 2008, the judge overseeing the case reduced the jurys 2006 damages award from $34 million to approximately $6.1 million and ordered a new trial on the issue of willfulness. Following the new trial held in June of 2009, the court found our infringement to have been willful, and in January 2011 the court awarded Power Integrations final damages in the amount of $12.2 million. We have challenged the final damages award, willfulness finding and other issues on appeal. Power Integrations also appealed aspects of the trial courts ruling, including damages. On January 11, 2012, the U.S. Court of Appeals for the Federal Circuit heard oral arguments on our appeal. We expect a ruling prior to the end of 2012.
POWI 2: On May 23, 2008, Power Integrations filed another lawsuit against us, Fairchild Semiconductor Corporation and our wholly owned subsidiary System General Corporation in the U.S. District Court for the District of Delaware, alleging infringement of three patents. Of the three patents claimed in that lawsuit, two were asserted against us and Fairchild Semiconductor Corporation in the October 2004 lawsuit described above. In 2011, POWI added a fourth patent to this case.
On October 14, 2008, Fairchild Semiconductor Corporation and System General Corporation filed a patent infringement lawsuit against Power Integrations in the U.S. District Court for the District of Delaware, alleging that certain PWM integrated circuit products infringe one or more claims of two U.S. patents owned by System General. The lawsuit seeks monetary damages and an injunction preventing the manufacture, use, sale, offer for sale or importation of Power Integrations products found to infringe the asserted patents.
Both lawsuits were consolidated and heard together in Delaware District Court in a jury trial in April of 2012. On April 27, 2012, the jury found that Power Integrations infringed one of the two U.S. patents owned by System General and upheld the validity of both System General patents. In the same case, the jury found that we infringed two of four U.S. patents asserted by Power Integrations and that we had induced our customers to infringe the asserted patents. The jury also upheld the validity of the asserted Power Integrations patents. The verdict concluded the first phase of trial in the litigation. Willfulness and damages in the case will be determined in a second phase, which has yet to be scheduled and may occur after appeals of the first phase.
POWI 3: On November 4, 2009, Power Integrations, Inc. filed a complaint for patent infringement against us and two of our subsidiaries in the United States District Court for the Northern District of California alleging that several of our products infringe three of Power Integrations patents. One of those patents has since been dropped from the case. We intend to put on a vigorous defense against these claims. In the same lawsuit we have filed counterclaims against Power Integrations, alleging Power Integrations products infringe certain claims of one of our patents. Trial has yet to be scheduled in the case.
POWI 4: On February 10, 2010 Fairchild and System General filed a lawsuit in Suzhou, China against four Power Integrations entities and seven vendors. The lawsuit claims that Power Integrations violates certain Fairchild/System General patents. Fairchild is seeking an injunction against the Power Integration products and over $17.0 million in damages. Power Integrations attempted to have the Fairchild/System General patents declared invalid in proceedings before the Chinese Patent Office. Based on the Patent Offices ruling, three of three of the four patents asserted by Fairchild will continue in the case.
Hearings comparable to a trial in U.S. litigation were held in January, May and July 2012 and we anticipate that the court will rule on the case before the end of 2012.
POWI 5: On May 1, 2012, we sued Power Integrations in United States District Court for the District of Delaware. The lawsuit accuses Power Integrations LinkSwitch-PH LED power conversion products of violating three of our patents. Power Integrations has counterclaimed against us asserting five Power Integrations patents but has not specified any of our products to date.
Other Legal Claims. From time to time we are involved in legal proceedings in the ordinary course of business. We believe that there is no such ordinary-course litigation pending that could have, individually or in the aggregate, a material adverse effect on our business, financial condition, results of operations or cash flows.
We analyze potential outcomes from current litigation in accordance with the Contingency Topic of the FASB ASC. Accordingly, we analyze such outcomes as loss contingencies, and divide them into three categories based on the possibility that the contingency will give rise to an actual loss. The first category represents contingencies for which we believe the possibility of a loss is remote. For contingencies in this category, we do not record a reserve or assess the range of possible losses. The second category represents contingencies for which losses are believed to be reasonably possible. For this category, we assess the range of possible losses but do not record a reserve. There are currently no contingencies in this category. The third category represents contingencies for which losses are believed to be probable. For this category, we determine the range of probable losses and record a reserve reflecting the best estimate within the range. For contingencies within this category, we currently believe the range of probable losses are approximately $14.0 million to $15.0 million. We believe the best estimate of losses within this range to be $14.1 million as of July 1, 2012 and have recorded this amount as a reserve. The amount reserved is based upon assessments of the potential liabilities using analysis of claims and historical experience in defending and resolving such claims.
A description of the risk factors associated with our business is set forth below. We review and update our risk factors each quarter. The description set forth below includes any changes to and supersedes the description of the risk factors associated with our business previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 25, 2011. The risks described below are not the only ones facing us. Additional risks not currently known to us or that we currently believe are immaterial also may impair our business operations and financial condition.
The price of our common stock has fluctuated widely in the past and may fluctuate widely in the future.
Our common stock is traded on The New York Stock Exchange and its price has fluctuated significantly in recent years. Additionally, our stock has experienced and may continue to experience significant price and volume fluctuations that could adversely affect its market price without regard to our operating performance. We believe that factors such as quarterly fluctuations in financial results, earnings below analysts estimates and financial performance and other activities of other publicly traded companies in the semiconductor industry could cause the price of our common stock to fluctuate substantially. In addition, our common stock, the stock market in general and the market for shares of semiconductor industry-related stocks in particular have experienced extreme price fluctuations which have often been unrelated to the operating performance of the affected companies. Similar fluctuations in the future could adversely affect the market price of our common stock.
We maintain a backlog of customer orders that is subject to cancellation, reduction or delay in delivery schedules, which may result in lower than expected revenues.
We manufacture products primarily pursuant to purchase orders for current delivery or to forecast, rather than pursuant to long-term supply contracts. The semiconductor industry is occasionally subject to double booking and rapid changes in customer outlooks or unexpected build ups of inventory in the supply channel as a result of shifts in end market demand and macro economic conditions. Accordingly, many of these purchase orders or forecasts may be revised or canceled without penalty. As a result, we must commit resources to the manufacture of products without binding purchase commitments from customers. Even in cases where our standard terms and conditions of sale or other contractual arrangements do not permit a customer to cancel an order without penalty, we may from time to time accept cancellations to maintain customer relationships or because of industry practice, custom or other factors. Our inability to sell products after we devote significant resources to them could have a material adverse effect on both our levels of inventory and revenues. While we currently believe our inventory levels are appropriate for the current economic environment, continued global economic uncertainty may result in lower than expected demand. While we anticipate increasing demand in many of our markets, lower demand than anticipated may impact our customers target inventory levels. During 2011 channel inventory increased. We are focusing on reducing channel inventories in 2012; however our current business forecasting is still qualified by the risk that our backlog may deteriorate as a result of customer cancellations.
Downturns in the highly cyclical semiconductor industry or changes in end user market demands could reduce the profitability and overall value of our business, which could cause the trading price of our stock to decline or have other adverse effects on our financial position.
The semiconductor industry is highly cyclical, and the value of our business may decline as a result of market response to this cyclicality. As we have experienced in the past, uncertainty in global economic conditions may continue to negatively affect us and the rest of the semiconductor industry, by causing us to experience backlog cancellations, higher inventory levels and reduced demand for our products. We may experience renewed, possibly severe and prolonged, downturns in the future as a result of this cyclicality. Even as demand increases following such downturns, our profitability may not increase because of price competition and supply shortages that historically accompany recoveries in demand. In addition, we may experience significant fluctuations in our profitability as a result of variations in sales, product mix, end user markets, the costs associated with the introduction of new products, and our efforts to reduce excess inventories that may have built up as a result of any of these factors. The markets for our products depend on continued demand for consumer electronics such as personal computers, cellular telephones, tablet devices, digital cameras, and automotive, household and industrial goods. Deteriorating global economic conditions may cause these end user markets to experience decreases in demand that could adversely affect our business and future prospects.
Our failure to execute on our cost reduction initiatives and the impact of such initiatives could adversely affect our business.
We continue to take cost reduction initiatives to keep pace with the evolving economic and competitive conditions. These actions include closing our four-inch manufacturing line in South Korea and converting to 8 inch wafers in Salt Lake City, Utah, Bucheon, South Korea and South Portland, Maine. Additionally, we initiated several insourcing programs to replace higher-cost outside subcontractors with internal manufacturing, we lowered our materials costs and implemented workforce reductions in an effort to simplify operations, improve productivity and reduce costs.
We cannot guarantee that we will successfully implement any of these actions, or if these actions and other actions we may take will help reduce costs. Because restructuring activities involve changes to many aspects of our business, the cost reductions could adversely impact productivity and sales to an extent we have not anticipated. Even if we fully execute and implement these activities and they generate the anticipated cost savings, there may be other unforeseeable and unintended factors or consequences that could adversely impact our profitability and business.
We may not be able to develop new products to satisfy changing customer demands or we may develop the wrong products.
Our success is largely dependent upon our ability to innovate and create revenues from new product introductions. Failure to develop new technologies, or react to changes in existing technologies, could materially delay development of new products and lead to decreased revenues and a loss of market share to our competitors. The semiconductor industry is characterized by rapidly changing technologies and industry standards, together with frequent new product introductions. Our financial performance depends on our ability to identify important new technology advances and to design, develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. While new products often command higher prices and higher profit margins, we may not successfully identify new
product opportunities and develop and bring new products to market or succeed in selling them for use in new customer applications in a timely and cost-effective manner. Products or technologies developed by other companies may render our products or technologies obsolete or noncompetitive. Many of our competitors are larger, older and more established companies with greater engineering and research and development resources than us. If we fail to identify a fundamental shift in technologies or in our product markets such failure could have material adverse effects on our competitive position within the industry. In addition, to remain competitive, we must continue our efforts to reduce die sizes, develop new packages and improve manufacturing yields. We cannot assure you that we can accomplish these goals.
If some original equipment manufacturers do not design our products into their equipment, our revenue may be adversely affected.
We depend on our ability to have original equipment manufacturers (OEMs), or their contract manufacturers, choose our products. Frequently, an OEM will incorporate or specifically design our products into the products it produces. In such cases the OEM may identify our products, with the products of a limited number of other vendors, as approved for use in particular OEM applications. Without design wins, we may only be able to sell our products to customers as a secondary source, if at all. If an OEM designs another suppliers product into one of its applications, it is more difficult for us to achieve future design wins for that application because changing suppliers involves significant cost, time, effort and risk for the OEM. Even if a customer designs in our products, we are not guaranteed to receive future sales from that customer. We may be unable to achieve these design wins because of competition or a products functionality, size, electrical characteristics or other aspect of its design or price. Additionally, we may be unable to service expected demand from the customer. In addition, achieving a design win with a customer does not ensure that we will receive significant revenue from that customer and we may be unable to convert design into actual sales.
We depend on demand from the consumer, original equipment manufacturer, contract manufacturing, industrial, automotive and other markets we serve for the end market applications which incorporate our products. Reduced consumer or corporate spending due to increased energy and commodity prices or other economic factors could affect our revenues.
If we provide revenue, margin or earnings per share guidance, it is generally based on certain assumptions we make concerning the health of the overall economy and our projections of future consumer and corporate spending. If our projections of these expenditures are inaccurate or based upon erroneous assumptions, our revenues, margins and earnings per share could be adversely affected. For example, beginning in the third quarter of 2011, we observed progressively weakening order rates which we attributed to uncertainty and deterioration of global economic conditions. While order rates and profitability are beginning to improve, we cannot be certain that a change in consumer demand or a deepening financial crisis in Europe will not have an adverse effect on our business.
Our failure to protect our intellectual property rights could adversely affect our future performance and growth.
Failure to protect our intellectual property rights may result in the loss of valuable technologies. We rely on patent, trade secret, trademark and copyright law to protect such technologies. These laws are subject to legislative and regulatory change or through changes in court interpretations of those laws and regulations. For example, there have been recent developments in the laws and regulations governing the issuance and assertion of patents in the U.S., including modifications to the rules governing patent prosecution. There have also been court rulings on the issues of willfulness, obviousness and injunctions, that may affect our ability to obtain patents and/or enforce our patents against others. Some of our technologies are not covered by any patent or patent application. With respect to our intellectual property generally, we cannot assure you that:
In addition, effective patent, trademark, copyright and trade secret protection may be unavailable, limited or not applied for in some countries. We cannot assure that we will be able to effectively enforce our intellectual property rights in every country in which our products are sold or manufactured.
We also seek to protect our proprietary technologies, including technologies that may not be patented or patentable, in part by confidentiality agreements and, if applicable, inventors rights agreements with our collaborators, advisors,
employees and consultants. We cannot assure you that these agreements will not be breached, that we will have adequate remedies for any breach or that such persons or institutions will not assert rights to intellectual property arising out of such research. We have non-exclusive licenses to some of our technology from National Semiconductor, Infineon, Samsung Electronics and other companies. These companies may license such technologies to others, including our competitors or may compete with us directly. In addition, National Semiconductor and Infineon have limited royalty-free, worldwide license rights to some of our technologies. National Semiconductor was purchased by Texas Instruments in 2011. If necessary or desirable, we may seek licenses under patents or intellectual property rights claimed by others. However, we cannot assure you that we will obtain such licenses or that the terms of any offered licenses will be acceptable to us. The failure to obtain a license from a third party for technologies we use could cause us to incur substantial liabilities and to suspend the manufacture or shipment of products or our use of processes requiring the technologies.
Our failure to obtain or maintain the right to use some technologies may negatively affect our financial results.
Our future success and competitive position depend in part upon our ability to obtain or maintain proprietary technologies used in our principal products. From time to time we are required to defend against claims by competitors and others of intellectual property infringement. Claims of intellectual property infringement and litigation regarding patent and other intellectual property rights are commonplace in the semiconductor industry and are frequently time consuming and costly. From time to time, we may be notified of claims that we may be infringing patents issued to other companies. Such claims may relate both to products and manufacturing processes. We may engage in license negotiations regarding these claims from time to time. Even though we maintain procedures to avoid infringing others rights as part of our product and process development efforts, it is impossible to be aware of every possible patent which our products may infringe, and we cannot assure you that we will be successful in our efforts to avoid infringement claims. Furthermore, even if we conclude our products do not infringe anothers patents, others may not agree. We have been and are involved in lawsuits, and could become subject to other lawsuits, in which it is alleged that we have infringed upon the patent or other intellectual property rights of other companies. For example, since October 2004, we have been in litigation with Power Integrations, Inc. See Item 3, Legal Proceedings. Our involvement in this litigation and future intellectual property litigation, or the costs of avoiding or settling litigation by purchasing licenses rights or by other means, could result in significant expense to our company, adversely affecting sales of the challenged products or technologies and diverting the efforts and attention of our technical and management personnel, whether or not such litigation is resolved in our favor. We may decide to settle patent infringement claims or litigation by purchasing license rights from the claimant, even if we believe we are not infringing, in order to reduce the expense of continuing the dispute or because we are not sufficiently confident that we would eventually prevail. In the event of an adverse outcome as a defendant in any such litigation, we may be required to:
We cannot assure you that we would be successful in such development or acquisition or that such licenses would be available under reasonable terms. Any such development, acquisition or license could require the expenditure of substantial time and other resources.
We may not be able to consummate future acquisitions or successfully integrate acquisitions into our business.
We have made numerous acquisitions of various sizes since we became an independent company in 1997 and we plan to pursue additional acquisitions of related businesses. The costs of acquiring and integrating related businesses, or our failure to integrate them successfully into our existing businesses, could result in our company incurring unanticipated expenses and losses. In addition, we may not be able to identify or finance additional acquisitions or realize any anticipated benefits from acquisitions we do complete.
We are constantly evaluating acquisition opportunities and consolidation possibilities and are frequently conducting due diligence or holding preliminary discussions with respect to possible acquisition transactions, some of which could be significant.
If we acquire another business, the process of integrating an acquired business into our existing operations may result in unforeseen operating difficulties and may require us to use significant financial resources on the acquisition that may otherwise be needed for the ongoing development or expansion of existing operations. Some of the risks associated with acquisitions include:
In addition, we may encounter unforeseen obstacles or costs in the integration of other businesses we acquire.
Possible future acquisitions could result in the incurrence of additional debt, contingent liabilities and amortization expenses related to intangible assets, all of which could have a material adverse effect on our financial condition and operating results.
We may face risks associated with dispositions of assets and businesses.
From time to time we may dispose of assets and businesses in an effort to grow our more profitable product lines. When we do so, we face certain risks associated with these exit activities, including but not limited the risk that we will disrupt service to our customers, the risk of inadvertently losing other business not related to the exit activities, the risk that we will be unable to effectively continue, terminate, modify and manage supplier and vendor relationships, and the risk that we may be subject to consequential claims from customers or vendors as a result of eliminating, or transferring the production of affected products or the renegotiation of commitments related to those products.
We depend on suppliers for timely deliveries of raw materials of acceptable quality. Production time and product costs could increase if we were to lose a primary supplier or if we experience a significant increase in the prices of our raw materials. Product performance could be affected and quality issues could develop as a result of a significant degradation in the quality of raw materials we use in our products.
Our manufacturing processes use many raw materials, including silicon wafers, gold, copper lead frames, mold compound, ceramic packages and various chemicals and gases. Our manufacturing operations depend upon our ability to obtain adequate supplies of raw materials on a timely basis. Our results of operations could be adversely affected if we were unable to obtain adequate supplies of raw materials in a timely manner or if the costs of raw materials increased significantly. If the prices of these raw materials rise significantly we may be unable to pass on our increased operating expenses to our customers. This could result in decreased profit margins for the products in which the materials are used. Results could also be adversely affected if there is a significant degradation in the quality of raw materials used in our products, or if the raw materials give rise to compatibility or performance issues in our products, any of which could lead to an increase in customer returns or product warranty claims. Although we maintain rigorous quality control systems, errors or defects may arise from a supplied raw material and be beyond our detection or control. For example, some phosphorus-containing mold compound received from one supplier and incorporated into our products in the past resulted in a number of claims for damages from customers. We purchase some of our raw materials such as silicon wafers, lead frames, mold compound, ceramic packages and chemicals and gases from a limited number of suppliers on a just-in-time basis. From time to time, suppliers may extend lead times, limit supplies or increase prices due to capacity constraints or other factors. We subcontract a minority of our wafer fabrication needs, primarily to Taiwan Semiconductor Manufacturing Company, Advanced Semiconductor Manufacturing Corporation, Central Semiconductor Manufacturing
Corporation, Jilin Magic Semiconductor, Macronix International Co. Ltd., and Phenitec Semiconductor. In order to maximize our production capacity, some of our back-end assembly and testing operations are also subcontracted. Primary back-end subcontractors include , Advance Semiconductor Engineering, Inc., AIC Semicondutor Sdn Bhd, Amkor Technology, AUK Semiconductor PTE, Ltd, GEM Services, Inc., Greatek Electronics, Inc., Hana Microelectronics Ltd, Liteon, Inc., Tak Cheong Electronics (Holdings) Co. Ltd, United Test and Assembly Center Thai Ltd., and Vigilant Technology Company, Ltd. Our operations and ability to satisfy customer obligations could be adversely affected if our relationships with these subcontractors were disrupted or terminated.
Delays in expanding capacity at existing facilities, implementing new production techniques, or incurring problems associated with technical equipment malfunctions, all could adversely affect our manufacturing efficiencies.
Our manufacturing efficiency is an important factor in our profitability, and we cannot assure you that we will be able to maintain our manufacturing efficiency or increase 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 or other difficulties in the manufacturing process can lower yields. We are constantly looking for ways to expand capacity or improve efficiency at our manufacturing facilities. For example, we are currently in the process of converting our facilities in South Korea and Utah from 6 inch wafers to 8 inch wafers. As is common in the semiconductor industry, we may experience difficulty in completing transitions to new manufacturing processes at existing facilities. As a consequence, we have suffered delays in product deliveries or reduced yields in the past and may experience such delays again in the future.
We may experience delays or problems in bringing new manufacturing capacity to full production. Such delays, as well as possible problems in achieving acceptable yields, or product delivery delays relating to existing or planned new capacity could result from, 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.
We rely on subcontractors to reduce production costs and to meet manufacturing demands, which may adversely affect our results of operations.
Many of the processes we use in manufacturing our products are complex requiring, among other things, a high degree of technical skill and significant capital investment in advanced equipment. In some circumstances, we may decide that it is more cost effective to have some of these processes performed by qualified third party subcontractors. In addition, we may utilize a subcontractor to fill unexpected customer demand for a particular product or process or to guaranty supply of a particular product that may be in great demand. More significantly, as a result of the expense incurred in qualifying multiple subcontractors to perform the same function, we may designate a subcontractor as a single source for supplying a key product or service. If a single source subcontractor were to fail to meet our contractual requirements, our business could be adversely affected and we could incur production delays and customer cancellations as a result. We would also be required to qualify other subcontractors, which would be time consuming and cause us to incur additional costs. In addition, even if we qualify alternate subcontractors, those subcontractors may not be able to meet our delivery, quality or yield requirements, which could adversely affect our results of operations. In addition to these operational risks, some of these subcontractors are smaller businesses that may not have the financial ability to acquire the advanced tools and equipment necessary to fulfill our requirements. In some circumstances, we may find it necessary to provide financial support to our subcontractors in the form of advance payments, loans, loan guarantees, equipment financing and similar financial arrangements. In those situations, we could be adversely impacted if the subcontractor failed to comply with its financial obligations to us.
Compliance with new regulations regarding the use of conflict minerals could limit the supply and increase the cost of certain metals used in manufacturing our products.
Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act), requires the SEC to promulgate new disclosure requirements for manufacturers of products containing certain minerals which are mined from the Democratic Republic of Congo and adjoining countries. These conflict minerals are commonly found in metals used in the manufacture of semiconductors. Manufacturers are also required to disclose their efforts to prevent the sourcing of such minerals and metals produced from them. The new disclosure rules will take effect after the first full fiscal year following the promulgation of the SECs final rules. The implementation of these new
regulations may limit the sourcing and availability of some of the metals used in the manufacture of our products. The regulations may also reduce the number of suppliers who provide conflict-free metals, and may affect our ability to obtain products in sufficient quantities or at competitive prices. Finally, some of our customers may elect to disqualify us as a supplier if we are unable to verify that the metals used in our products free of conflict minerals.
Approximately two-thirds of our sales are made to distributors who can terminate their relationships with us with little or no notice. The termination of a distributor could reduce sales and result in inventory returns.
Distributors accounted for 62% of our net sales for the six months ended July 1, 2012. Our top five distributors worldwide accounted for 22% of our net sales for the six months ended July 1, 2012. As a general rule, we do not have long-term agreements with our distributors, and they may terminate their relationships with us with little or no advance notice. Distributors generally offer competing products. The loss of one or more of our distributors, or the decision by one or more of them to reduce the number of our products they offer or to carry the product lines of our competitors, could have a material adverse effect on our business, financial condition and results of operations. The termination of a significant distributor, whether at our or the distributors initiative, or a disruption in the operations of one or more of our distributors, could reduce our net sales in a given quarter and could result in an increase in inventory returns.
The semiconductor business is very competitive, especially in the markets we serve, and increased competition could reduce the value of an investment in our company.
We participate in the standard component or multi-market segment of the semiconductor industry. While the semiconductor industry is generally highly competitive, the multi-market segment is particularly so. Our competitors offer equivalent or similar versions of many of our products, and customers may switch from our products to our competitors products on the basis of price, delivery terms, product performance, quality, reliability and customer service or a combination of any of these factors. Competition is especially intense in the multi-market semiconductor segment because it is relatively easy for customers to switch between suppliers of more standardized, multi-market products like ours. In the past we have experienced decreases in prices during down cycles in the semiconductor industry, and this may occur again as a result of the recent downturn in global economic conditions. Even in strong markets, price pressures may emerge as competitors attempt to gain a greater market share by lowering prices. We compete in a global market and our competitors are companies of various sizes in various countries around the world. Many of our competitors are larger than us and have greater financial resources available to them. As such, they tend to have a greater ability to pursue acquisition candidates and can better withstand adverse economic or market conditions. Additionally, companies with whom we do not currently compete may introduce new products that may cause them to compete with us in the future.
We may not be able to attract or retain the technical or management employees necessary to remain competitive in our industry.
Our continued success depends on our ability to attract, motivate and retain skilled personnel, including technical, marketing, management and staff personnel. In the semiconductor industry, the competition for qualified personnel, particularly experienced design engineers and other technical employees, is intense, particularly when the business cycle is improving. During such periods competitors may try to recruit our most valuable technical employees. While we devote a great deal of our attention to designing competitive compensation programs aimed at accomplishing this goal, specific elements of our compensation programs may not be competitive with those of our competitors and there can be no assurance that we will be able to retain our current personnel or recruit the key personnel we require.
If we must reduce our use of equity awards to compensate our employees, our competitiveness in the employee marketplace could be adversely affected. Our results of operations could vary as a result of changes in our stock-based compensation programs.
Like most technology companies, we have a history of using employee stock based incentive programs to recruit and retain our workforce in a competitive employment marketplace. Our success will depend in part upon the continued use of stock options, restricted stock units, deferred stock units and performance-based equity awards as a compensation tool. While this is a routine practice in many parts of the world, foreign exchange and income tax regulations in some countries make this practice more and more difficult. Such regulations tend to diminish the value of equity compensation to our employees in those countries. With regard to all equity based compensation, our current practice is to seek stockholder approval for increases in the number of shares available for grant under the Fairchild Semiconductor 2007 Stock Plan as well as other amendments that may be adopted from time to time which require stockholder approval. If these proposals
do not receive stockholder approval, we may not be able to grant stock options and other equity awards to employees at the same levels as in the past, which could adversely affect our ability to attract, retain and motivate qualified personnel, and we may need to increase cash compensation in order to attract, retain and motivate employees, which could adversely affect our results of operations. Additionally, since 2009 we have relied almost exclusively on grants of restricted stock units and performance based equity awards in place of stock options. While we believe that our compensation policies are competitive with our peers, we cannot provide any assurance that we have not, and will not continue in the future to lose opportunities to recruit and retain key employees as a result of these changes.
Changes in forecasted stock-based compensation expense could impact our gross margin percentage, research and development expenses, marketing, general and administrative expenses and our tax rate.
We may face product warranty or product liability claims that are disproportionately higher than the value of the products involved.
Our products are typically sold at prices that are significantly lower than the cost of the equipment or other goods in which they are incorporated. For example, our products that are incorporated into a personal computer may be sold for several dollars, whereas the personal computer might be sold by the computer maker for several hundred dollars. Although we maintain rigorous quality control systems, we manufacture and sell approximately 16 billion individual semiconductor devices per year to customers around the world, and in the ordinary course of our business we receive warranty claims for some of these products that are defective or that do not perform to published specifications. Since a defect or failure in our product could give rise to failures in the goods that incorporate them (and consequential claims for damages against our customers from their customers), we may face claims for damages that are disproportionate to the revenues and profits we receive from the products involved. We attempt, through our standard terms and conditions of sale and other customer contracts, to limit our liability by agreeing only to replace the defective goods or refund the purchase price. Nevertheless, we have received claims for other charges, such as for labor and other costs of replacing defective parts or repairing the products into which the defective products are incorporated, lost profits and other damages. In addition, our ability to reduce such liabilities, whether by contracts or otherwise, may be limited by the laws or the customary business practices of the countries where we do business. And, even in cases where we do not believe we have legal liability for such claims, we may choose to pay for them to retain a customers business or goodwill or to settle claims to avoid protracted litigation. Our results of operations and business could be adversely affected as a result of a significant quality or performance issue in our products, if we are required or choose to pay for the damages that result. For example, from 2001 to 2008 we received claims from a number of customers seeking damages resulting from certain products manufactured with a phosphorus-containing mold compound, and we were named in lawsuits relating to these mold compound claims.
Our operations and business could be significantly harmed by natural disasters.
Our manufacturing facilities in China, South Korea, Malaysia, the Philippines and many of the third party contractors and suppliers that we currently use are located in countries that are in seismically active regions of the world where earthquakes and other natural disasters, such as floods and typhoons may occur. While we take precautions to mitigate these risks, we cannot be certain that they will be adequate to protect our facilities in the event of a major earthquake, flood, typhoon or other natural disaster. Although we maintain insurance for some of the damage that may be caused by natural disasters, our insurance coverage may not be sufficient to cover all of our potential losses and would not cover us for lost business. As a result, a natural disaster in one of these regions could severely disrupt the operation of our business and have a material adverse effect on our financial condition and results of operations.
Natural disasters could affect our supply chain or our customer base which, in turn, could have a negative impact on our business, the cost of and demand for our products and our results of operations.
While the earthquake and tsunami in Japan and flooding in Thailand did not materially impact us, the occurrence of natural disasters in certain regions, could have a negative impact on our supply chain, our ability to deliver products, the cost of our products and the demand for our products. These events could cause consumer confidence and spending to decrease or result in increased volatility to the U.S. and worldwide economies. Any such occurrences could have a material adverse effect on our business, our results of operations and our financial condition.
Our international operations subject our company to risks not faced by domestic competitors.
Through our subsidiaries we maintain significant operations and facilities in the Philippines, Malaysia, China, South Korea and Singapore. We have sales offices and customers around the world. Approximately 75% of our revenues in first six months of 2012 were from Asia. The following are some of the risks inherent in doing business on an international level:
We acquired significant operations and revenues when we acquired a business from Samsung Electronics and, as a result, are subject to risks inherent in doing business in Korea, including political risk, labor risk and currency risk.
We have significant operations and sales in South Korea and are subject to risks associated with doing business there. Korea accounted for approximately 10% of our revenue for the six months ended July 1, 2012.
Relations between South Korea and North Korea have been tense over most of South Koreas history, and more recent concerns over North Koreas nuclear capability, and relations between the U.S. and North Korea, have created a global security issue that may adversely affect Korean business and economic conditions. We cannot assure you as to whether or when this situation will be resolved or change abruptly as a result of current or future events. An adverse change in economic or political conditions in South Korea or in its relations with North Korea could have a material adverse effect on our Korean subsidiary and our company. In addition to other risks disclosed relating to international operations, some businesses in South Korea are subject to labor unrest.
Our Korean sales are increasingly denominated primarily in U.S. dollars while a significant portion of our Korean operations costs of goods sold and operating expenses are denominated in South Korean won. Although we have taken steps to fix the costs subject to currency fluctuations and to balance won revenues and won costs as much as possible, a significant change in this balance, coupled with a significant change in the value of the won relative to the dollar, could have a material adverse effect on our financial performance and results of operations (see Item 7a, Quantitative and Qualitative Disclosures about Market Risk).
A change in foreign tax laws or a difference in the construction of current foreign tax laws by relevant foreign authorities could result in us not recognizing any anticipated benefits.
Some of our foreign subsidiaries have been granted preferential income tax or other tax holidays as an incentive for locating in those jurisdictions. A change in the foreign tax laws or in the construction of the foreign tax laws governing these tax holidays, or our failure to comply with the terms and conditions governing the tax holidays, could result in us not recognizing the anticipated benefits we derive from them, which would decrease our profitability in those jurisdictions. While we continue to monitor the tax holidays, the income tax laws governing the tax holidays, and our compliance with the terms and conditions of the tax holidays there is still a risk that we may not be able to recognize the anticipated benefits of these tax holidays.
We have significantly expanded our manufacturing operations in China and, as a result, will be increasingly subject to risks inherent in doing business in China, which may adversely affect our financial performance.
We expect a significant portion of our production from our Suzhou, China facility will be exported out of China, however, we are hopeful that a significant portion of our future revenue will result from the Chinese markets in which our
products are sold, and from demand in China for goods that include our products. Our ability to operate in China may be adversely affected by changes in that countrys laws and regulations, including those relating to taxation, foreign exchange restrictions, import and export tariffs, environmental regulations, land use rights, property and other matters. In addition, our results of operations in China are subject to the economic and political situation there. We believe that our operations in China are in compliance with all applicable legal and regulatory requirements. However, there can be no assurance that Chinas central or local governments will not impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures. Changes in the political environment or government policies could result in revisions to laws or regulations or their interpretation and enforcement, increased taxation, restrictions on imports, import duties or currency revaluations. In addition, a significant destabilization of relations between China and the U.S. could result in restrictions or prohibitions on our operations or the sale of our products in China. The legal system of China relating to foreign trade is relatively new and continues to evolve. There can be no certainty as to the application of its laws and regulations in particular instances. Enforcement of existing laws or agreements may be sporadic and implementation and interpretation of laws inconsistent. Moreover, there is a high degree of fragmentation among regulatory authorities resulting in uncertainties as to which authorities have jurisdiction over particular parties or transactions.
We are subject to many environmental laws and regulations that could affect our operations or result in significant expenses.
Increasingly stringent environmental regulations restrict the amount and types of pollutants that can be released from our operations into the environment. While the cost of compliance with environmental laws has not had a material adverse effect on our results of operations historically, compliance with these and any future regulations could require significant capital investments in pollution control equipment or changes in the way we make our products. In addition, because we use hazardous and other regulated materials in our manufacturing processes, we are subject to risks of liabilities and claims, regardless of fault, resulting from our use, transportation, emission, discharge, storage, recycling or disposal of hazardous materials, including personal injury claims and civil and criminal fines, any of which could be material to our cash flow or earnings. For example:
Although most of our known environmental liabilities are covered by indemnification agreements with Raytheon Company, National Semiconductor Corporation, Samsung Electronics and Intersil Corporation, these indemnities are limited to conditions that occurred prior to the consummation of the transactions through which we acquired facilities from those companies. National Semiconductor was purchased by Texas Instruments in 2011. Moreover, we cannot assure you that their indemnity obligations to us for the covered liabilities will be available, or, if available, adequate to protect us.
Our senior credit facility limits our flexibility and places restrictions on the manner in which we run our operations.
At July 1, 2012 we had total debt of $300.1 million and the ratio of this debt to equity was approximately 0.2 to 1. As of July 1, 2012, our credit facility consists of a $400 million in a revolving line of credit. Adjusted for outstanding letters of credit, we had up to $98.7 million available under the revolving loan portion of the senior credit facility. In addition, there is a $150 million uncommitted incremental revolving loan feature. Despite the significant reductions we have made in our long-term debt, we continue to carry indebtedness which could have significant consequences on our operations. For example, it could:
We may not be able to generate the necessary amount of cash to service our indebtedness, which may require us to refinance our indebtedness or default on our scheduled debt payments. Our ability to generate cash depends on many factors beyond our control.
Our historical financial results have been, and we anticipate that our future financial results may be subject to substantial fluctuations. While we currently have sufficient cash flow to satisfy all of our current obligations, we cannot assure you that our business will continue to generate sufficient cash flow from operations to enable us to pay our indebtedness or to fund our other liquidity needs in the future. Further, we can make no assurances that our currently anticipated cost savings and operating improvements will be realized on schedule or at all, or that future borrowings will be available to us under our senior credit facility in an amount sufficient to satisfy our liquidity needs. In addition, because our senior credit facility has a variable interest rate, our cost of borrowing will increase if market interest rates increase. If we are unable to meet our expenses and debt obligations, we may need to refinance all or a portion of our indebtedness on or before maturity, sell assets or raise equity. We cannot assure you that we would be able to renew or refinance any of our indebtedness, sell assets or raise equity on commercially reasonable terms or at all, which could cause us to default on our obligations and impair our liquidity. Restrictions imposed by the credit agreement relating to our senior credit facility restrict or prohibit our ability to engage in or enter into some business operating and financing arrangements, which could adversely affect our ability to take advantage of potentially profitable business opportunities.
The operating and financial restrictions and covenants in the credit agreement relating to our senior credit facility may limit our ability to finance our future operations or capital needs or engage in other business activities that may be in our interests. The credit agreement imposes significant operating and financial restrictions on us that affect our ability to incur additional indebtedness or create liens on our assets, pay dividends, sell assets, engage in mergers or acquisitions, make investments or engage in other business activities. These restrictions could place us at a disadvantage relative to our competitors many of which are not subject to such limitations.
In addition, the senior credit facility also requires us to maintain specified financial ratios. Our ability to meet those financial ratios can be affected by events beyond our control, and we cannot assure you that we will meet those ratios. As of July 1, 2012, we were in compliance with these ratios. A breach of any of these covenants, ratios or restrictions could result in an event of default under the senior credit facility. Upon the occurrence of an event of default under the senior credit facility, the lenders could elect to declare all amounts outstanding under the senior credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against our assets, including any collateral granted to them to secure the indebtedness. If the lenders under the senior credit facility accelerate the payment of the indebtedness, we cannot assure you that our assets would be sufficient to repay in full that indebtedness and our other indebtedness.
We have investments in auction rate securities that subject us to market risk which could adversely affect our liquidity and financial results.
As of July 1, 2012, we owned auction rate securities with a par value of $49.5 million and market value of $26.0 million. We originally purchased these securities believing them to be safe, short-term and highly liquid investments. However,
as a result of the systemic failure of the auction rate securities market, these securities are no longer liquid. While we continue to accrue and receive interest on these securities at the contractual rate, there can be no assurance that there will ever be an active market for our auction rate securities. Uncertainties in the credit and capital markets could lead to further downgrades of our auction rate securities and additional impairments. Additionally, auction failures have limited our ability to fully recover the par value of our investment in the short term and even if we hold the securities to maturity, the long-term value of the auction rate securities may potentially be impacted by issuer defaults. We do not anticipate that the lack of liquidity or future downgrades and impairments will materially impact our ability to fund out working capital needs, capital expenditures or other business requirements.
Security breaches and other disruptions could compromise the integrity of our information and expose us to liability, which would cause our business and reputation to suffer.
We routinely collect and store sensitive data, including intellectual property and other proprietary information about our business and that of our customers, suppliers and business partners. The secure processing, maintenance and transmission of this information is critical to our operations and business strategy. Despite our security measures, our information technology and infrastructure may be vulnerable to attacks by hackers or breached due to employee error, malfeasance or other disruptions. Any such breach could compromise our networks and the information stored there could be accessed, publicly disclosed, lost or stolen. Any such access, disclosure or other loss of information could result in legal claims or proceedings and liability under laws that protect the privacy of personal information. It could also result in regulatory penalties, disrupt our operations and the services we provide to customers, damage our reputation and cause a loss of confidence in our products and services, which could adversely affect our business/operating margins, revenues and competitive position.
All of these shares were purchased by the company in open-market transactions and were authorized by the Board of Directors. The purchase of these shares satisfied the conditions of the safe harbor provided by the Securities Exchange Act of 1934.
For the majority of restricted stock units granted, the number of shares issued on the date the restricted stock units vest is net of the minimum statutory withholding requirements that we pay in cash to the appropriate taxing authorities on behalf of our employees. Although these withheld shares are not issued or considered common stock repurchases and are not included in the table above, the cash paid for taxes is treated in the same manner as common stock repurchases in our financial statements, as they reduce the number of shares that would have been issued upon vesting.
Items 3, 4 and 5 are not applicable and have been omitted.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.