PIXELWORKS, INC quarterly report, Q3 FY2012

Pixelworks, Inc. Form 10-Q Summary

Reporting period: Quarter and nine months ended September 30, 2012. The interim financial statements are unaudited and prepared under U.S. GAAP. Pixelworks designs and licenses video and pixel-processing semiconductors and software for digital displays and projectors. The company reported 18.4 million common shares outstanding as of October 31, 2012.

Financial Highlights

Metric	Q3 2012	Q3 2011	9M 2012	9M 2011
Revenue	$16.285 million	$17.391 million	$46.139 million	$47.781 million
Gross profit	$7.788 million	$8.456 million	$23.256 million	$22.447 million
Gross margin	48%	49%	50%	47%
Operating loss	$0.471 million	$1.167 million	$2.622 million	$6.216 million
Net loss	$0.400 million	$1.083 million	$2.137 million	$4.609 million
Loss per share	$0.02	$0.06	$0.12	$0.29

All dollar amounts in the table are in millions except per-share data. The company remained unprofitable, but losses narrowed substantially year over year. Research and development expense declined 21% in Q3 and 17% for the first nine months, primarily because of offsets from a customer co-development agreement. Selling, general and administrative expense declined 2% in Q3 but increased 2% year to date.

Cash Flow, Liquidity and Capital Structure

• Cash and cash equivalents were $15.566 million at September 30, 2012, compared with $15.092 million at December 31, 2011.
• Operating activities generated $2.759 million of cash during the first nine months of 2012, compared with $0.040 million used in the prior-year period.
• Investing activities used $1.275 million, primarily for property and equipment purchases.
• Financing activities used $1.010 million, primarily for payments on asset financings; common-stock issuances provided $0.444 million.
• The company reported no borrowings under its revolving line of credit and stated that it had no short- or long-term debt, although asset-financing liabilities remained on the balance sheet.
• The $10 million secured revolving facility was available subject to borrowing-base limitations and covenants. Management stated that existing working capital and available credit were expected to fund requirements for the next twelve months.
• Total assets were $35.164 million and total shareholders’ equity was $17.637 million at September 30, 2012.

Material Changes Versus Prior Comparable Period

• Revenue declined 6% in Q3 and 3% for the first nine months. IC product revenue declined, while licensing revenue contributed $0.6 million in Q3 and $5.0 million year to date; no comparable licensing revenue was reported in 2011.
• Average selling prices declined approximately 15%, primarily because of a greater mix of lower-priced MotionEngine co-processor ICs and lower pricing on earlier-generation digital projector products. Q3 unit volume increased 7%, while nine-month unit volume was relatively unchanged.
• Gross margin declined one percentage point in Q3 because of product mix and pricing, but increased three points year to date due primarily to higher-margin licensing revenue.
• The company recognized $3.063 million of co-development reimbursement against R&D expense in Q3 and $0.437 million in Q2. The arrangement includes an initial $3.5 million payment and two additional $1.75 million milestone payments, but does not guarantee future product sales.
• Compared with the first nine months of 2011, 2012 did not include the prior-year $1.6 million patent-sale gain or $0.264 million gain on sale of marketable securities.
• Accounts receivable declined to $3.756 million from $4.557 million at year-end, while inventories increased to $4.729 million from $4.107 million.

Outlook, Risks and Unusual Items

• Management expected fourth-quarter 2012 revenue to decline from Q3 because of macroeconomic weakness and seasonality, particularly lower digital-projector revenue after the historically stronger third quarter.
• Management expected Q4 R&D expense to increase because additional co-development costs were expected before further milestone offsets in 2013.
• Revenue and receivables were highly concentrated: one distributor represented 50% of nine-month revenue, and the top five end customers represented 54%. Japan accounted for approximately $26.681 million, or about 58%, of nine-month revenue.
• The company relies on a limited number of semiconductor foundries and assembly and test vendors, generally without long-term supply agreements. Supplier disruption, manufacturing defects, capacity constraints, or component shortages could materially affect results.
• The semiconductor and display markets are subject to rapid technological change, intense competition, declining selling prices, cyclical demand and lengthy design-win cycles.
• All reported backlog orders were cancelable, and design wins did not constitute binding purchase commitments.
• The revolving credit facility was scheduled to expire on December 21, 2012, creating a refinancing or liquidity risk if continued access was needed.
• The company had incurred operating losses since 2004 and maintained a full valuation allowance against essentially all U.S. deferred tax assets. Federal and state net operating loss carryforwards could be limited by expiration or an ownership change under Section 382.
• Income-tax benefits were primarily attributable to reversals of foreign tax contingencies. The company expected approximately $0.390 million of further uncertain-tax-position reductions within twelve months due to statute expirations.
• Pixelworks reported no material off-balance-sheet arrangements and stated that existing legal matters were not expected to have a material adverse effect, although litigation and indemnification outcomes remained uncertain.
• Cash equivalents were primarily held in U.S.-denominated money-market funds. The company had foreign-currency exposure and substantial Asian operating, customer and manufacturing concentration.

Important Facts for Investors to Verify

1. Whether the revolving credit facility was renewed, replaced or allowed to expire after December 21, 2012.
2. Whether the co-development customer completed the remaining milestones and whether the project generated commercial sales despite having no purchase commitment.
3. The sustainability of licensing revenue and its effect on gross margin, given the absence of comparable 2011 licensing revenue.
4. Customer and distributor concentration, including the ability of the principal distributor and largest end customers to maintain orders and payments.
5. Inventory levels, warranty reserves and potential write-downs amid declining average selling prices and changing product demand.
6. Progress toward profitability and the company’s ability to fund ongoing R&D without additional debt or equity financing.
7. Potential limitations on net operating loss utilization arising from ownership changes, including transactions involving Becker Drapkin Management.