Business context and reporting period
Photronics, Inc. manufactures photomasks used in semiconductor integrated-circuit (IC) and flat-panel-display (FPD) production. This Form 10-Q covers the quarter ended May 4, 2014, and the first six months of fiscal 2014; comparisons are with the periods ended April 28, 2013. Amounts below are in U.S. dollars unless stated otherwise.
On April 4, Photronics combined its Taiwan subsidiary PSMC with DNP’s DPTT. Photronics owns 50.01% of the resulting PDMC and consolidates it; DNP retains 49.99%. PDMC contributed $13.1 million of revenue and $0.4 million of net income from acquisition through quarter-end.
Financial performance and position
| Metric | Q2 FY2014 | Q2 FY2013 | Six months FY2014 | Six months FY2013 |
|---|---|---|---|---|
| Net sales | $104.9m | $106.7m | $206.4m | $206.5m |
| Gross margin | 21.2% | 23.2% | 21.8% | 22.2% |
| Operating income | $2.8m | $8.1m | $8.5m | $13.3m |
| Net income | $16.0m | $5.4m | $18.0m | $8.3m |
| Net income attributable to Photronics shareholders | $15.5m | $4.9m | $17.5m | $7.2m |
| Diluted EPS | $0.22 | $0.08 | $0.27 | $0.12 |
Reported net income includes a $16.4 million acquisition gain; it is not indicative of recurring operating performance. Operating income fell despite reported net income rising. Pro forma results treating the acquisition as if it occurred at the start of each comparative period, and excluding the gain and specified acquisition costs, show Q2 net income attributable to Photronics shareholders of $1.0 million and diluted EPS of $0.02, versus $6.2 million and $0.10 a year earlier. The filing cautions that these pro forma figures are illustrative, not predictive.
Q2 sales declined 1.7%: IC revenue fell 6.8% to $76.6 million, while FPD revenue rose 15.6% to $28.3 million. Six-month sales were essentially flat. Lower high-end IC sales weighed on revenue; increased high-end FPD sales partly offset the decline. Q2 gross margin contracted to 21.2%, which management attributed to lower sales and increased manufacturing costs associated with DPTT. SG&A rose 10.4% to $13.4 million, including $2.0 million of acquisition costs; R&D increased 30.4% to $5.9 million, primarily due to advanced IC technology-node development.
For the six months, operating cash flow was $39.9 million, versus $35.9 million; investing cash outflow was $38.8 million, including $42.4 million of property and equipment purchases, partly offset by $4.5 million of cash acquired. Financing cash outflow was $25.1 million, primarily debt repayments. Cash decreased by $23.8 million to $191.8 million.
At May 4, 2014, total borrowings were $168.9 million, including $115.0 million of 3.25% convertible notes due April 2016, $22.1 million of 5.5% convertible notes due October 2014, and capital leases. The October 2014 notes were classified as long-term because management intended to repay them using the credit facility. The company had no credit-facility borrowings and $50 million available under its facility, expandable to $75 million. Working capital was $209.4 million; current assets were $340.8 million and current liabilities $131.4 million. Cash exceeded total borrowings by approximately $22.9 million.
Capital expenditure commitments were approximately $74 million. Cash held by foreign subsidiaries was $118.0 million; repatriation may trigger U.S. and local taxes. The company remitted $35.1 million of previously reinvested PSMC earnings in connection with the acquisition.
Material changes, outlook and risks
- The DPTT transaction added assets and operations in Taiwan and produced the one-time $16.4 million gain. Acquisition fair values remain provisional, and reported Q2 includes $2.0 million of acquisition costs.
- Management expects most revenue growth to come from Asia, with additional North American growth potentially supported by technology licensed from Micron. No quantitative revenue, earnings, or margin guidance is provided.
- Management says available resources should cover planned capital spending and anticipated working-capital needs for the next twelve months, but notes that additional financing may not be available on favorable terms if cash needs exceed resources.
- Demand depends on photomask design activity and technology transitions, not simply semiconductor or display sales. The business is cyclical, seasonal, and high-fixed-cost; utilization, pricing, product mix, and customer orders can affect margins and cash flow. Management is assessing its global manufacturing footprint, which could lead to closures, redeployments, impairments, workforce reductions, or added capacity.
- Key transaction risks include integration costs, customer overlap or lost sales, and costs to maintain or eliminate duplicate activities. Further risks include foreign-exchange movements, financing and capital needs, and possible additional contributions to the MP Mask and PDMC joint ventures. A 10% adverse currency movement was estimated to produce a $4.0 million pretax unrealized loss.
- The company reported compliance with credit-facility covenants and effective disclosure controls. Ordinary-course claims and proceedings were not expected by management to have a material effect.
Important facts for investors to verify
- How much of reported earnings reflects the nonrecurring $16.4 million acquisition gain, and how do ongoing PDMC results compare with the illustrative pro forma figures?
- Whether the acquired operations meet expected integration, customer-retention, cost, and utilization objectives, and whether provisional acquisition valuations change.
- How the company will fund the $74 million of capital commitments and repay the $22.1 million convertible notes due October 2014; verify facility availability and covenant headroom.
- How much foreign-held cash is practically available for U.S. needs after potential taxes, and whether joint-venture capital calls could increase liquidity requirements.
- Whether IC demand, FPD growth, margins, and cash generation improve or weaken as industry cycles, seasonality, and manufacturing utilization change.