UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 24, 2004
Commission File No. 1-8139
ZARLINK SEMICONDUCTOR INC.
(Exact name of registrant as specified in its charter)
CANADA NONE
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
400 March Road,
Ottawa, Ontario, Canada K2K 3H4
(Address of principal executive offices) (Postal Code)
(613)-592-0200
(Registrant's telephone number, including area code)
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 is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act) Yes [ X ] No [ ]
As at October 22, 2004 there were 127,308,973 Common Shares of Zarlink
Semiconductor Inc., no par value, issued and outstanding.
ZARLINK SEMICONDUCTOR INC.
TABLE OF CONTENTS
Item No. Page No.
- -------- --------
PART I - FINANCIAL INFORMATION.................................................................................................3
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS.....................................................................................3
CONSOLIDATED BALANCE SHEETS......................................................................................3
CONSOLIDATED STATEMENTS OF INCOME (LOSS).........................................................................4
CONSOLIDATED STATEMENTS OF CASH FLOWS............................................................................5
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS...................................................................6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS................................15
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...........................................................24
ITEM 4. CONTROLS AND PROCEDURES..............................................................................................24
PART II - OTHER INFORMATION...................................................................................................25
ITEM 5. OTHER INFORMATION ...................................................................................................25
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K....................................................................................25
SIGNATURES....................................................................................................................25
2
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
Zarlink Semiconductor Inc.
CONSOLIDATED BALANCE SHEETS
(In millions of U.S. dollars, except share amounts, U.S. GAAP)
(Unaudited)
Sept. 24, March 26,
2004 2004
-------------------- --------------------
ASSETS
Current assets:
Cash and cash equivalents $ 34.0 $ 27.0
Short-term investments 47.2 54.8
Restricted cash 10.0 10.0
Trade accounts receivable, less allowance for doubtful accounts of $0.3
(March 26, 2004 - $0.3) 26.4 24.1
Other receivables 4.6 2.9
Note receivable - net of deferred gain of $7.6 (March 26, 2004 - $17.1) 0.1 0.1
Inventories 24.4 20.8
Prepaid expenses and other 6.6 4.5
-------------------- --------------------
153.3 144.2
Fixed assets - net of accumulated depreciation of $156.5 (March 26, 2004 -
$152.5) 38.2 41.1
Deferred income tax assets - net 7.7 7.5
Other assets 4.6 4.6
-------------------- --------------------
$ 203.8 $ 197.4
==================== ====================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 17.1 $ 15.0
Employee-related accruals 10.1 11.1
Income and other taxes payable 7.1 7.9
Provisions for exit activities 1.4 2.7
Other accrued liabilities 8.4 10.9
Deferred credits 0.2 0.7
Current portion of long-term debt -- 0.1
-------------------- --------------------
44.3 48.4
Long-term debt 0.1 0.1
Pension liabilities 17.3 16.7
-------------------- --------------------
61.7 65.2
-------------------- --------------------
Redeemable preferred shares, unlimited shares authorized; 1,377,100 shares
issued and outstanding (March 26, 2004 - 1,390,300) 17.6 17.6
-------------------- --------------------
Commitments (Note 8)
Shareholders' equity:
Common shares, unlimited shares authorized; no par value; 127,308,973 shares
issued and outstanding (March 26, 2004 - 127,301,411) 768.4 768.4
Additional paid-in capital 2.4 2.3
Deficit (613.8) (623.5)
Accumulated other comprehensive loss (32.5) (32.6)
-------------------- --------------------
124.5 114.6
-------------------- --------------------
$ 203.8 $ 197.4
==================== ====================
(See accompanying notes to the consolidated financial statements)
3
Zarlink Semiconductor Inc.
CONSOLIDATED STATEMENTS OF INCOME (LOSS)
(In millions of U.S. dollars, except per share amounts, U.S. GAAP)
(Unaudited)
Three Months Ended Six Months Ended
--------------------------------- --------------------------------
Sept. 24, Sept. 26, Sept. 24, Sept. 26,
2004 2003 2004 2003
---------------- ---------------- --------------- ---------------
Revenue $ 58.8 $ 46.6 $ 114.6 $ 100.3
Cost of revenue 32.0 27.2 62.6 55.3
---------------- ---------------- --------------- ---------------
Gross margin 26.8 19.4 52.0 45.0
---------------- ---------------- --------------- ---------------
Expenses:
Research and development 15.6 19.2 30.5 38.4
Selling and administrative 11.0 14.2 21.7 25.8
Asset impairment and other -- 5.3 -- 5.3
Gain on sale of business (2.9) -- (9.9) --
---------------- ---------------- --------------- ---------------
23.7 38.7 42.3 69.5
---------------- ---------------- --------------- ---------------
Income (loss) from operations 3.1 (19.3) 9.7 (24.5)
Interest income 0.2 0.3 0.4 0.6
Foreign exchange gain (loss) (0.1) 0.1 (0.4) (0.9)
Interest expense -- (0.3) -- (0.3)
---------------- ---------------- --------------- ---------------
Income (loss) before income taxes 3.2 (19.2) 9.7 (25.1)
Income tax recovery -- 0.3 1.0 --
---------------- ---------------- --------------- ---------------
Net income (loss) for the period $ 3.2 $ (18.9) $ 10.7 $ (25.1)
================ ================ =============== ===============
Net income (loss) attributable to common shareholders after
preferred share dividends $ 2.7 $ (19.4) $ 9.7 $ (26.1)
================ ================ =============== ===============
Net income (loss) per common share:
Basic and diluted $ 0.02 $ (0.15) $ 0.08 $ (0.20)
================ ================ =============== ===============
Weighted-average number of common shares outstanding
(millions):
Basic 127.3 127.3 127.3 127.3
================ ================ =============== ===============
Diluted 127.3 127.3 127.4 127.3
================ ================ =============== ===============
(See accompanying notes to the consolidated financial statements)
4
Zarlink Semiconductor Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions of U.S. dollars, U.S. GAAP)
(Unaudited)
Six Months Ended
----------------------------------
Sept. 24, Sept. 26,
2004 2003
----------------- --------------
CASH PROVIDED BY (USED IN)
Operating activities:
Net income (loss) for the period $ 10.7 $ (25.1)
Depreciation of fixed assets 4.6 6.9
Amortization of other assets -- 0.8
Other non cash changes in operating activities (9.7) 6.8
Stock compensation expense 0.1 --
Deferred income taxes (0.2) (0.8)
Decrease (increase) in working capital
Trade accounts and other receivables (3.9) (5.6)
Inventories (3.7) 2.3
Prepaid expenses and other (2.2) (2.7)
Payable and other accrued liabilities (3.2) (0.1)
Deferred credits (0.4) (0.2)
----------------- --------------
Total (7.9) (17.7)
----------------- --------------
Investing activities:
Purchased short-term investments (54.6) (75.1)
Matured short-term investments 62.2 129.4
Expenditures for fixed and other assets (2.0) (3.2)
Proceeds from disposal of fixed and other assets 0.4 0.6
Proceeds from repayment of note receivable 9.9 --
----------------- --------------
Total 15.9 51.7
----------------- --------------
Financing activities:
Repayment of capital lease liabilities and long-term debt (0.1) (0.4)
Payment of dividends on preferred shares (1.0) (1.0)
Repurchase of preferred shares -- (0.5)
Decrease in restricted cash -- 0.6
----------------- --------------
Total (1.1) (1.3)
----------------- --------------
Effect of currency translation on cash 0.1 0.2
----------------- --------------
Increase in cash and cash equivalents 7.0 32.9
Cash and cash equivalents, beginning of period 27.0 23.5
----------------- --------------
Cash and cash equivalents, end of period $ 34.0 $ 56.4
================= ==============
(See accompanying notes to the consolidated financial statements)
5
Zarlink Semiconductor Inc.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In millions of U.S. dollars, except share and per share amounts, U.S. GAAP)
(Unaudited)
1. Basis of presentation
These unaudited interim consolidated financial statements have been
prepared by Zarlink Semiconductor Inc. (Zarlink or the Company) in
United States (U.S.) dollars, unless otherwise stated, and in
accordance with accounting principles generally accepted in the U.S.
for interim financial statements and with the instructions to Form 10-Q
and Regulation S-X pertaining to interim financial statements.
Accordingly, these interim consolidated financial statements do not
include all information and footnotes required by generally accepted
accounting principles (GAAP) for complete financial statements. In the
opinion of management of the Company, the unaudited interim
consolidated financial statements reflect all adjustments, which
consist only of normal and recurring adjustments, necessary to present
fairly the financial position at September 24, 2004, the results of
operations of the Company for the three and six month periods ended
September 24, 2004 and September 26, 2003, and cash flows of the
Company for the six month periods ended September 24, 2004 and
September 26, 2003, in accordance with U.S. GAAP, applied on a
consistent basis. The consolidated financial statements include the
accounts of Zarlink and its wholly owned subsidiaries. Intercompany
transactions and balances have been eliminated. Canadian GAAP financial
statements for interim periods are also prepared and presented to
shareholders.
The balance sheet at March 26, 2004 has been derived from the audited
consolidated financial statements at that date but does not include all
of the information and footnotes required by generally accepted
accounting principles for complete financial statements. These
financial statements should be read in conjunction with the financial
statements and notes thereto contained in the Company's Annual Report
on Form 10-K for the year ended March 26, 2004. The Company's fiscal
year-end is the last Friday in March.
The results of operations for the periods presented are not necessarily
indicative of the results to be expected for the full year or future
periods.
2. Significant accounting policies
a) Revenue Recognition
The Company recognizes revenue from the sale of semiconductor products,
which are primarily non-commodity, specialized products that are
proprietary in design and used by multiple customers. Customer
acceptance provisions for performance requirements are generally based
on seller-specified criteria, and are demonstrated prior to shipment.
The Company generates revenue through direct sales and sales to
distributors, of which distributor sales account for approximately 48%,
48%, and 35% of semiconductor product sales in Fiscal 2004, 2003, and
2002, respectively.
In accordance with Securities and Exchange Commission Staff Accounting
Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements, as
well as SAB No. 104, Revenue Recognition, the Company recognizes
product revenue through direct sales and sales to distributors when the
following fundamental criteria are met: (i) persuasive evidence of an
arrangement exists, (ii) transfer of title has occurred, (iii) the
price to the customer is fixed or determinable, and (iv) collection of
the resulting receivable is reasonably assured.
In addition, the Company has agreements with its distributors that
cover two sales programs, specifically ship and debit claims, which
relate to pricing adjustments based upon distributor resale, and stock
rotations claims, which relate to certain stock return rights earned
against subsequent sales. The Company accrues for these programs as a
reduction of revenue at the time of shipment, based on historical sales
returns, analysis of credit memo data, and other factors known at the
time. The Company believes that these programs are common to
distributor agreements in the industry, and it is appropriate that the
distributor sales are recognized as revenue at the time of shipment in
accordance with Statement of Financial Accounting Standard (SFAS) No.
48 because of the following:
i) The Company's price to the buyer is substantially fixed or
determinable at the date of sale.
ii) The distributor is obligated to pay the Company, and the
obligation is not contingent on resale of the product.
6
iii) The distributor's obligation to the Company would not be
changed in the event of theft or physical destruction or
damage of the product.
iv) The distributor has economic substance apart from that
provided by the Company.
v) The Company does not have significant obligations for future
performance to directly bring about resale of the product by
the distributor.
vi) The amount of future returns can be reasonably estimated.
b) Income Taxes
Income taxes are accounted for using the liability method of accounting
for income taxes. Under this method, deferred income tax assets and
liabilities are determined based on differences between the tax and
accounting bases of assets and liabilities as well as for the benefit
of losses available to be carried forward to future years for tax
purposes that are more likely than not to be realized. Deferred income
tax assets and liabilities are measured using enacted tax rates that
apply to taxable income in the years in which temporary differences are
expected to be recovered or settled. Deferred income tax assets are
recognized only to the extent, in the opinion of management, it is more
likely than not that the deferred income tax assets will be realized in
the future.
Management periodically reviews the Company's provision for income
taxes and valuation allowance to determine whether the overall tax
estimates are reasonable. When management performs its quarterly
assessments of the provision and valuation allowance, it may be
determined that an adjustment is required. This adjustment may have a
material impact on the Company's financial position and results of
operations.
c) Inventories
Inventories are valued at the lower of average cost and net realizable
value for work-in-process and finished goods, and lower of average cost
and current replacement cost for raw materials. The cost of inventories
includes material, labor and manufacturing overhead.
3. Stock-based compensation
Pro forma information regarding net income (loss) and net income (loss)
per share is required by SFAS 123 for awards granted or modified after
April 1, 1995, as if the Company had accounted for its stock-based
awards to employees under the fair value method of SFAS 123. The fair
value of the Company's stock-based awards to employees was estimated
using a Black-Scholes option pricing model. The Black-Scholes option
valuation model was developed for use in estimating the fair value of
traded options that have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have
characteristics significantly different from those of traded options,
and because changes in the subjective input assumptions can materially
affect the fair value estimate, in management's opinion, the existing
models do not necessarily provide a reliable single measure of the fair
value of its employee stock options.
Three Months Ended Six Months Ended
--------------------------------- -------------------------------
Sept. 24, Sept. 26, Sept. 24, Sept. 26,
2004 2003 2004 2003
---------------- ---------------- --------------- --------------
Net income (loss), as reported $ 3.2 $ (18.9) $ 10.7 $ (25.1)
Adjustments:
Stock compensation expense, as reported -- -- 0.1 --
Pro forma stock compensation expense (3.0) (3.1) (5.9) (6.2)
------------------------------------------------------------------
Pro forma net income (loss) $ 0.2 $ (22.0) $ 4.9 $ (31.3)
------------------------------------------------------------------
Net income (loss) per common share, as reported
Basic and diluted $ 0.02 $ (0.15) $ 0.08 $ (0.20)
------------------------------------------------------------------
Pro forma net income (loss) per common share
Basic and diluted $ -- $ (0.17) $ 0.03 $ (0.25)
------------------------------------------------------------------
Based upon the fair value method of accounting for stock compensation
expense, the pro forma net income for the three and six months ended
September 24, 2004, was decreased by $3.0 and $5.8, respectively, as
compared
7
to the reported net income. For the three and six month fiscal periods
ended September 26, 2003, the pro forma net loss was increased by $3.1
and $6.2, respectively.
Pro forma financial information required by SFAS 123 has been
determined as if the Company had accounted for its employee stock
options using the Black-Scholes fair value option pricing model with
the following weighted-average assumptions for the three and six month
periods ended September 24, 2004 and September 26, 2003:
Three Months Ended Six Months Ended
--------------------------------- -------------------------------
Sept. 24, Sept. 26, Sept. 24, Sept. 26,
2004 2003 2004 2003
---------------- ---------------- --------------- --------------
Weighted-average fair value price of the options $ 1.82 $ 2.39 $ 1.96 $ 2.31
granted during the period
Risk free interest rate 3.83% 3.01% 3.95% 3.10%
Dividend yield Nil Nil Nil Nil
Volatility factor of the expected market price of the
Company's common stock 64.7% 69.2% 65.1% 68.7%
Weighted-average expected life of the options 4.2 years 3.4 years 4.1 years 3.4 years
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period on a
straight-line basis.
4. Inventories
Sept. 24, March 26,
2004 2004
-------------------------------------
Raw materials $ 2.5 $ 2.2
Work-in-process 16.7 13.3
Finished goods 5.2 5.3
-------------------------------------
$ 24.4 $ 20.8
=====================================
5. Note receivable
Sept. 24, March 26,
2004 2004
-------------------------------------
Note receivable, non-interest bearing $ 7.7 $ 17.2
Less: Deferred gain (7.6) (17.1)
-------------------------------------
$ 0.1 $ 0.1
=====================================
Based upon the terms of the Plymouth Foundry sale agreement with X-FAB
Semiconductor Foundries AG (X-FAB), payment of the note receivable was
scheduled to occur in two installments of $10.0 and $8.0. During the
first quarter of Fiscal 2005, X-FAB exercised its option to make early
payments totaling $7.0 against the $10.0 installment due in the second
quarter of Fiscal 2005. The note receivable was discounted by $0.1 as a
result of the early payment. During the second quarter of Fiscal 2005,
the Company received a payment of $2.9 from X-FAB, to settle the
installment due at that time. As a result of these payments, in the
three and six month periods ended September 24, 2004, the Company
recognized a gain on sale of business of $2.9 and $9.9, respectively.
The final installment payment of $8.0 is due from X-FAB in the first
quarter of Fiscal 2006.
6. Provisions for exit activities
In response to economic downturns in the semiconductor industry, the
Company implemented restructuring activities in Fiscal 2002 and Fiscal
2004.
During Fiscal 2004, the Company incurred workforce reduction costs of
$7.0 as a result of reducing the Company's employee base by
approximately 240 employees, globally across all job categories and
business units. As a result of this workforce reduction program and the
streamlining of its operations, the Company also recorded a charge of
8
$0.6 in Fiscal 2004, included in asset impairment and other, related to
excess space under lease contract in Canada. Of the $7.6 of
restructuring provision recorded, $4.6 related to the Network
Communication segment, $2.4 related to the Consumer Communications
segment, and $0.6 related to the Ultra Low-Power segment. In Fiscal
2005, the Company paid the remaining $0.7 related to these workforce
reductions.
The remaining balance in the restructuring provision relates to idle
and excess space as a result of exit activities implemented and
completed in Fiscal 2002 and Fiscal 2004. The cumulative amount
incurred to date related to these activities is $9.5. Costs of $8.9
were recorded as special charges in Fiscal 2002, and costs of $0.6 were
reflected in asset impairment and other charges in Fiscal 2004.
With the exception of lease payments on the idle and excess space
estimated at $1.4, which will be paid over the lease term unless
settled earlier, the Company has completed substantially all of the
activities associated with these restructuring plans.
The following table summarizes the continuity of these restructuring
provisions for the three and six months ended September 24, 2004:
Workforce Lease and contract
Reduction settlement Total
-------------------- ---------------------- --------------------
Balance, March 26, 2004 $ 0.7 $ 2.0 $ 2.7
Cash drawdowns during quarter (0.7) (0.5) (1.2)
-------------------- ---------------------- --------------------
Balance, June 25, 2004 -- 1.5 1.5
Cash drawdowns during quarter -- (0.1) (0.1)
-------------------- ---------------------- --------------------
Balance, September 24, 2004 $ -- $ 1.4 $ 1.4
==================== ====================== ====================
7. Guarantees
Performance guarantees are contracts that contingently require the
guarantor to make payments to the guaranteed party based on another
entity's failure to perform under an obligating agreement. The Company
has an outstanding performance guarantee related to a managed services
agreement (project agreement) undertaken by the Systems business, which
was sold to companies controlled by Dr. Terence H. Matthews on February
16, 2001 and is now operated as Mitel Networks Corporation (Mitel).
This performance guarantee remained with the Company following the sale
of the Systems business to Dr. Matthews. The project agreement and the
Company's performance guarantee extend until July 16, 2012. The terms
of the project agreement continue to be fulfilled by Mitel. The maximum
potential amount of future undiscounted payments the Company could be
required to make under the guarantee, at September 24, 2004, was $36.1
(20.0 British Pounds), assuming the Company is unable to secure the
completion of the project. The Company was not aware of any factors as
at September 24, 2004 that would prevent the project's completion under
the terms of the agreement. In the event that Mitel is unable to
fulfill the commitments of the project agreement, the Company believes
that an alternate third-party contractor could be secured to complete
the agreement requirements. The Company has not recorded a liability in
its consolidated financial statements associated with this guarantee.
The Company periodically has entered into agreements with customers and
suppliers that include limited intellectual property indemnifications
that are customary in the industry. These guarantees generally require
the Company to compensate the other party for certain damages and costs
incurred as a result of third party intellectual property claims
arising from these transactions. The nature of the intellectual
property indemnification obligations prevents the Company from making a
reasonable estimate of the maximum potential amount it could be
required to pay to its customers and suppliers. Historically, the
Company has not made any significant indemnification payments under
such agreements and no amount has been accrued in the accompanying
consolidated financial statements with respect to these indemnification
obligations.
In connection with the sale of the Systems business on February 16,
2001, the Company provided to the purchaser certain income tax
indemnities with an indefinite life and with no maximum liability for
the taxation periods up to February 16, 2001, the closing date of the
sale. As at September 24, 2004, the taxation years 2000 to February 16,
2001 are still subject to audit by taxation authorities in certain
foreign jurisdictions and are therefore still subject to the above
noted tax indemnities.
9
On November 19, 2002, the Company provided security to the financial
institution of a subsidiary in the form of a guarantee in relation to
the subsidiary's liability for custom and excise duties. As at
September 24, 2004, the maximum amount of the guarantee was $2.9 ($1.6
British Pounds).
The Company records a liability based on its historical experience with
warranty claims. The warranty accrual was immaterial for the three and
six month periods ended September 24, 2004.
Based upon the transition rules outlined in FASB Interpretation No. 45
(FIN 45), "Guarantor's Accounting and Disclosure Requirements for
Guarantees of Indebtedness of Others", no amounts have been recorded by
the Company related to the above-mentioned items.
8. Commitments
The Company had letters of credit outstanding as at September 24, 2004
of $9.5 (September 26, 2003 - $5.6), which expire within 3 years. Cash
and cash equivalents of $9.5 have been pledged as security against
certain outstanding letters of credit, and are presented as restricted
cash. Of this amount, $8.0 was issued to secure letters of credit
related to the Company's pension plan in Sweden, and $0.7 letters of
credit were outstanding related to the Company's Senior Executive
Retirement Plan (SERP). In addition, $0.8 was issued to secure certain
obligations under a performance guarantee and office lease arrangement.
The Company has also pledged $0.5 as security for a custom bond and
related credit facilities.
9. Redeemable preferred shares
During the three and six months ended September 24, 2004, there were no
preferred shares purchased by the Company, and 13,200 preferred shares
cancelled. These cancelled preferred shares had been repurchased during
Fiscal 2004.
During the second quarter of Fiscal 2005, the Company declared and paid
dividends on its redeemable preferred shares of $0.5 based on a
quarterly dividend of $0.38 (Cdn $0.50) per share.
10. Capital stock
a) The Company has not declared nor paid any dividends on its common
shares.
b) A summary of the Company's stock option activity is as follows:
Six Months Ended
-------------------------------------
Sept. 24, Sept. 26,
2004 2003
-------------------------------------
Outstanding Options:
Balance, beginning of period 11,534,680 10,828,557
Granted 333,000 109,500
Exercised (7,562) (10,617)
Forfeited (357,391) (997,883)
-------------------------------------
Balance, end of period 11,502,727 9,929,557
=====================================
As at September 24, 2004, there were 2,996,295 (March 26, 2004 -
2,971,904) options available for grant under the stock option plan
approved by the Company's shareholders on December 7, 2001. The
exercise price of outstanding stock options ranges from $2.66 to
$29.28 per share with exercise periods extending to September 2010.
The exercise price of stock options issued in Canadian dollars was
translated at the U.S. dollar exchange rate on September 24, 2004.
c) The net income (loss) per common share figures were calculated based
on the net income (loss) after the deduction of preferred share
dividends and using the weighted monthly average number of shares
outstanding during the respective periods. Diluted earnings per
share is computed in accordance with the treasury stock method based
on the average number of common shares and dilutive common share
equivalents.
10
The common shares and dilutive common share equivalents used in the
computation of the Company's basic and diluted earnings per common
share are as follows:
Three Months Ended Six Months Ended
--------------------------------- ---------------------------------
Sept. 24, Sept. 26, Sept. 24, Sept. 26,
2004 2003 2004 2003
--------------------------------- ---------------------------------
Weighted average common shares outstanding 127,308,973 127,274,679 127,305,973 127,274,187
Dilutive effect of stock options 37,019 -- 63,913 --
--------------------------------------------------------------------
Weighted average common shares outstanding,
assuming dilution 127,345,992 127,274,679 127,369,886 127,274,187
====================================================================
For the three months ended September 26, 2003, 537,993 stock options
have been excluded from the computation of diluted loss per share
because they were anti-dilutive due to the reported net loss for the
period (six months ended September 26, 2003 - 573,690 stock
options).
The following stock options were excluded from the computation of
common share equivalents because the options' exercise prices
exceeded the average market price of the common shares, thereby
making them anti-dilutive:
Three Months Ended Six Months Ended
--------------------------------- ---------------------------------
Sept. 24, Sept. 26, Sept. 24, Sept. 26,
2004 2003 2004 2003
--------------------------------- ---------------------------------
Number of outstanding options 11,164,789 7,451,043 10,931,289 7,401,043
Average exercise price per share $ 8.22 $ 10.56 $ 8.32 $ 10.59
The average exercise price of stock options granted in Canadian
dollars was translated at the closing period-end U.S. dollar
exchange rate.
11. Accumulated other comprehensive income (loss)
The components of total comprehensive income (loss) were as follows:
Three Months Ended Six Months Ended
---------------------------------- ----------------------------------
Sept. 24, Sept. 26, Sept. 24, Sept. 26,
2004 2003 2004 2003
---------------------------------- ----------------------------------
Net income (loss) for the period $ 3.2 $ (18.9) $ 10.7 $ (25.1)
Other comprehensive income (loss):
Realized net derivative (gains) losses on cash
flow hedges -- (0.1) 0.2 --
Unrealized net derivative gains (losses) on
cash flow hedges (0.1) 0.3 (0.1) 0.4
---------------------------------- ----------------------------------
Total comprehensive income (loss) for the
period $ 3.1 $ (18.7) $ 10.8 $ (24.7)
================================== ==================================
11
The changes to accumulated other comprehensive loss for the six months
ended September 24, 2004 were as follows:
Realized and
Cumulative Unrealized Net
Translation Gain (Loss) on
Account Derivatives Total
---------------- ---------------- ----------------
Balance, March 26, 2004 $ (32.4) $ (0.2) $ (32.6)
Change during the three months ended
June 25, 2004 -- 0.2 0.2
---------------- ---------------- ----------------
Balance, June 25, 2004 (32.4) -- (32.4)
Change during the three months ended
September 24, 2004 -- (0.1) (0.1)
---------------- ---------------- ----------------
Balance, September 24, 2004 $ (32.4) $ (0.1) $ (32.5)
================ ================ ================
The Company recorded an increase in other comprehensive income in the
six months ended September 24, 2004 of $0.1 as compared to a decrease
in other comprehensive loss of $0.4 in the six months ended September
26, 2003. These changes were attributable to the change in the fair
value of outstanding foreign currency option and forward contracts
related to the Company's hedging program that were designated as cash
flow hedges. The Company estimates that $0.1 of net derivative loss
included in other comprehensive income at September 24, 2004 will be
reclassified into earnings within the next six months.
12. Income taxes
There was no income tax expense recorded for the second quarter of
Fiscal 2005, compared with a recovery of $0.3 for the corresponding
period in Fiscal 2004. During the six months ended September 24, 2004,
an income tax recovery of $1.0 was recorded, compared with no recovery
in the same period of Fiscal 2004. The recovery of $1.0 related to the
release of previously recognized provisions no longer required as a
result of settlements with tax authorities, in addition to a recovery
of $0.3 relating to income tax refunds received in excess of provisions
previously recorded, offset by income tax expense of $0.3.
The Company has a valuation allowance against its deferred tax assets
at September 24, 2004 of $184.0 (March 26, 2004 - $176.8). The increase
relates mainly to losses incurred, partially offset by temporary
differences in the Company's domestic and foreign operations. Based on
historical taxable income and uncertainties relating to future taxable
income over the periods in which the deferred tax assets are
deductible, management has determined that it is not more likely than
not that the results of future operations will generate sufficient
taxable income to realize certain of its net deferred tax assets.
13. Information on business segments
Business Segments
The Company's operations are comprised of three reportable business
segments - Network Communications, Consumer Communications, and Ultra
Low-Power Communications. Reportable segments are business units that
offer different products and services, employ different production
processes and methods of distribution, sell to different customers, and
are managed separately because of these differences.
The Company targets the communications industry with products that
specialize in broadband connectivity solutions over wired, wireless and
optical media, as well as through ultra low-power communications
solutions. The Network Communications business segment offers products
that provide connectivity to the enterprise and metro sectors such as
feeder, aggregation and transmission applications, and products that
address the multi-protocol physical and network layers. The Consumer
Communications business segment offers products that allow users to
connect to the network. These products include wireless (for example,
cellular chipsets) and infotainment applications (for example, set-top
boxes and digital TV). The Ultra Low-Power Communications business
segment provides Application-Specific Integrated Circuit (ASIC) and
Application-Specific Standard Product (ASSP) solutions for applications
such as pacemakers, hearing aids, portable instruments and electronic
shelf labels.
12
The Chief Executive Officer (CEO) is the chief operating decision maker
in assessing the performance of the segments and the allocation of
resources to the segments. The CEO evaluates the financial performance
of each business segment and allocates resources based on operating
income. The Company does not allocate special charges or gains,
interest income, interest expense or income taxes to its reportable
segments. In addition, the Company does not use a measure of segment
assets to assess performance or allocate resources. As a result,
segmented asset information is not presented; however, depreciation of
fixed assets is allocated to the segments based on the estimated asset
usage. The accounting policies of the reportable segments are the same
as those of the Company as reflected in the consolidated financial
statements.
Network Consumer Ultra Low-Power Unallocated
Three Months Ended Sept. 24, 2004 Communications Communications Communications Recoveries Total
------------------- ------------------- ------------------ ------------- ---------------
Total external sales revenue $ 26.9 $ 20.6 $ 11.3 $ -- $ 58.8
Depreciation of buildings and equipment 1.1 0.8 0.4 -- 2.3
Gain on sale of business -- -- -- (2.9) (2.9)
Segment's operating income (loss) $ 3.0 $ (1.8) $ (1.0) $ 2.9 $ 3.1
Network Consumer Ultra Low-Power Unallocated
Three Months Ended Sept. 26, 2003 Communications Communications Communications Recoveries Total
------------------- ------------------- ------------------ ------------- ---------------
Total external sales revenue $ 25.0 $ 13.8 $ 7.8 $ -- $ 46.6
Depreciation of buildings and equipment 1.9 1.0 0.4 -- 3.3
Asset impairment and other 3.0 1.9 0.4 -- 5.3
Segment's operating loss $ (10.7) $ (6.6) $ (2.0) $ -- $ (19.3)
Network Consumer Ultra Low-Power Unallocated
Six Months Ended Sept. 24, 2004 Communications Communications Communications Recoveries Total
------------------- ------------------- ------------------ ------------- ---------------
Total external sales revenue $ 52.8 $ 39.8 $ 22.0 $ -- $ 114.6
Depreciation of buildings and equipment 2.1 1.6 0.9 -- 4.6
Gain on sale of business -- -- -- (9.9) (9.9)
Segment's operating income (loss) $ 5.1 $ (3.8) $ (1.5) $ 9.9 $ 9.7
Network Consumer Ultra Low-Power Unallocated
Six Months Ended Sept. 26, 2003 Communications Communications Communications Recoveries Total
------------------- ------------------- ------------------ ------------- ---------------
Total external sales revenue $ 54.3 $ 27.2 $ 18.8 $ -- $ 100.3
Depreciation of buildings and equipment 3.7 2.1 1.1 -- 6.9
Asset impairment and other 3.0 1.9 0.4 -- 5.3
Segment's operating loss $ (12.4) $ (11.1) $ (1.0) $ -- $ (24.5)
14. Pension plans
The Company has defined benefit pension plans in Sweden and Germany.
The total pension expense under these plans consisted of interest costs
on projected plan benefits. Total pension expense on defined benefit
pension plans for the three and six month periods ended September 24,
2004 was $0.2 and $0.4, respectively (three and six month periods ended
September 26, 2003 - $0.1 and $0.4, respectively).
As of September 24, 2004, the Company had not made any contributions to
these pension plans in Fiscal 2005.
13
15. Supplementary cash flow information
The following table summarizes the Company's other non cash changes in
operating activities:
Six Months Ended
-----------------------------------
Sept. 24, Sept. 26,
2004 2003
----------------- ----------------
(Gain) loss on disposal of fixed assets $ (0.3) $ 0.1
Gain on sale of business (9.9) --
Change in pension liabilities 0.6 1.6
Impairment of fixed assets -- 4.7
Provision for excess space under lease contract -- 0.6
Other (0.1) (0.2)
-------------------------------------
Other non cash changes in operating activities $ (9.7) $ 6.8
=====================================
16. Comparative figures
Certain of the Fiscal 2004 comparative figures have been reclassified
to conform to the presentation adopted in Fiscal 2005.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
(in millions of U.S. dollars, except per share amounts,
and in accordance with U.S. GAAP)
Overview
For almost 30 years, Zarlink Semiconductor Inc. has delivered the integrated
circuit (IC) building blocks that drive the capabilities of voice, enterprise,
broadband and wireless communications. Zarlink is a global provider of
microelectronics for voice and data networks, and consumer and ultra low-power
communications.
The following discussion and analysis explains trends in Zarlink's financial
condition and results of operations for the three and six months ended September
24, 2004, compared with the corresponding periods in the previous fiscal year.
This discussion is intended to help shareholders and other readers understand
the dynamics of Zarlink's business and the key factors underlying its financial
results. This discussion should be read in conjunction with the consolidated
financial statements and notes thereto included elsewhere in this Form 10-Q, and
with the Company's audited consolidated financial statements and notes thereto
for the fiscal year ended March 26, 2004.
Forward-Looking Statements
Certain statements in this Quarterly Report on Form 10-Q contain forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995 (the "Reform Act") that are based on current expectations, estimates and
projections about the industries in which the Company operates, management's
beliefs and assumptions made by management. These statements are not guarantees
of future performance and involve certain risks, uncertainties and assumptions,
which are difficult to predict. Accordingly, actual outcomes and results may
differ materially from results forecasted or suggested in such forward-looking
statements.
Such risks, uncertainties and assumptions include, among others, the following:
increasing price and product/service competition by foreign and domestic
competitors, including new entrants; rapid technological developments and
changes; the ability to continue to introduce competitive new products on a
timely, cost-effective basis; delays in product development; product mix; the
ability to ensure continuity of supply from outside fabrication services;
changes in environmental and other domestic and foreign governmental
regulations; protection and validity of patent and other intellectual property
rights; import protection and regulation; industry competition; industry
capacity and other industry trends; the ability of the Company to attract and
retain key employees; demographic changes and other factors referenced in the
Company's Annual Report on Form 10-K for the fiscal year ended March 26, 2004.
The above factors are representative of the risks, uncertainties and assumptions
that could affect the outcome of the forward-looking statements. In addition,
such statements could be affected by general industry and market conditions and
growth rates, general domestic and international economic conditions, including
interest rate and currency exchange rate fluctuations and other risks,
uncertainties and assumptions, as described in the Company's Annual Report on
Form 10-K for the fiscal year ended March 26, 2004, including those identified
under "Forward-Looking Statements and Risk Factors". In making these
forward-looking statements, which are identified by words such as "will",
"expects", "intends", "anticipates" and similar expressions, the Company claims
the protection of the safe-harbor for forward-looking statements contained in
the Reform Act. The Company undertakes no obligation to update publicly any
forward-looking statements whether as a result of new information, future events
or otherwise.
15
RESULTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED SEPTEMBER 24, 2004
Three Months Ended Six Months Ended
------------------------ -------------------------
Summary of Results from Operations Sept. 24, Sept. 26, Sept. 24, Sept. 26,
(millions of U.S. dollars, except per share amounts) 2004 2003 2004 2003
--------- ----------- ---------- -----------
Consolidated revenue $ 58.8 $ 46.6 $ 114.6 $ 100.3
Network Communications segment revenue 26.9 25.0 52.8 54.3
Consumer Communications segment revenue 20.6 13.8 39.8 27.2
Ultra Low-Power Communications segment revenue 11.3 7.8 22.0 18.8
Operating income (loss) 3.1 (19.3) 9.7 (24.5)
Network Communications segment operating income (loss) 3.0 (10.7) 5.1 (12.4)
Consumer Communications segment operating loss (1.8) (6.6) (3.8) (11.1)
Ultra Low-Power Communications segment operating loss (1.0) (2.0) (1.5) (1.0)
Unallocated gain 2.9 -- 9.9 --
Net income (loss) for the period 3.2 (18.9) 10.7 (25.1)
Net income (loss) per common share - basic and diluted 0.02 (0.15) 0.08 (0.20)
Weighted average common shares outstanding - millions
Basic 127.3 127.3 127.3 127.3
Diluted 127.3 127.3 127.4 127.3
Revenue in the second quarter of Fiscal 2005 was $58.8, up 26% from revenue of
$46.6 in the second quarter of Fiscal 2004. In the first six months of Fiscal
2005, revenue was $114.6, an increase of 14% from revenue of $100.3 in the same
period of Fiscal 2004. Despite continuing challenges in the semiconductor
industry, significant revenue improvements were achieved in the Company's
Consumer Communications and Ultra Low-Power business segments.
The Company experienced lower sequential bookings in the second quarter of
Fiscal 2005, consistent with typical seasonal trends through the summer months,
but the Company had higher bookings than those experienced during the same
period in Fiscal 2004.
In the second quarter of Fiscal 2005, the Company recorded net income of $3.2,
or $0.02 per share. This compares to a net loss of $18.9, or $0.15 per share, in
the second quarter of Fiscal 2004. The net income in the second quarter of
Fiscal 2005 included a gain on sale of foundry business of $2.9, and also
benefited from higher revenues and margins and lower operating expenses as a
result of the cost reduction activities implemented in Fiscal 2004. The loss in
the second quarter of Fiscal 2004 included costs of $3.4 related to reducing the
Company's global workforce by approximately 120 employees across all regions and
business units. In addition, the second quarter Fiscal 2004 loss included an
impairment loss on fixed assets of $4.7 resulting from the review of the ongoing
usage of the Company's testing equipment and enterprise resource planning
system, and a charge of $0.6 related to excess space under lease contract.
For the six months ended September 24, 2004, the Company recorded net income of
$10.7, or $0.08 per share. This compares to a net loss of $25.1, or $0.20 per
share, for the same period of Fiscal 2004. Net income for the first six months
of Fiscal 2005 includes a gain on sale of foundry business of $9.9. In addition,
higher revenues and margins and lower operating expenses due to cost reduction
activities implemented in Fiscal 2004, resulted in improvements as compared to
the same period in Fiscal 2004. The loss incurred in the six months ended
September 26, 2003 resulted primarily from low revenues and margins, as well as
expenses of $3.4 incurred in the workforce reduction and $5.3 in asset
impairment and excess space related activities undertaken in the second quarter
of Fiscal 2004.
Zarlink's operations are comprised of three reportable business segments -
Network Communications, Consumer Communications, and Ultra Low-Power
Communications. Zarlink targets the network and consumer communications
industries with offerings that specialize in broadband connectivity solutions
over wired, wireless and optical media. Zarlink's Ultra Low-Power communications
segment provides ultra low-power ASIC solutions for applications such as
pacemakers, hearing aids and portable instruments. Zarlink sells its products
through both direct and indirect channels of distribution. Factors affecting the
choice of distribution include, among others, end-customer type, the level of
product complexity, the stage of product introduction, geographic presence and
location of markets, and volume levels.
16
Network Communications
Three Months Ended Six Months Ended
---------------------------- ----------------------------
Sept. 24, Sept. 26, Sept. 24, Sept. 26,
(millions of U.S. dollars) 2004 2003 2004 2003
------------- ------------- ------------ --------------
Revenue $ 26.9 $ 25.0 $ 52.8 $ 54.3
============= ============= ============ ==============
As a % of total revenue 46% 54% 46% 54%
Operating income (loss) $ 3.0 $ (10.7) $ 5.1 $ (12.4)
============= ============= ============ ==============
Zarlink's Network Communications segment specializes in microelectronic
solutions for broadband connectivity over wired and optical media. The product
line enables voice and data convergence for high-speed internet systems,
switching systems, and subscriber access systems. In simple terms, Network
Communications semiconductor products connect network equipment together.
Revenue for the second quarter of Fiscal 2005 totaled $26.9, up 8% from the
second quarter of Fiscal 2004. Reduced capital spending in the market continues
to impact demand by networking companies, however marginal improvements were
seen in the Company's other network and packet processing product lines, which
accounted for approximately 4% and 3%, respectively. During the first six months
of Fiscal 2005 revenue decreased to $52.8, down 3% from the same period in
Fiscal 2004. Declines were seen in most of the segment's product lines. The most
significant declines were seen in the Company's Timing and TSI, Voice
Processing, and Optical product lines, which accounted for approximately 2%, 1%,
and 1%, respectively, of the decrease. These declines were partially offset by
increased sales of the Company's legacy products, which accounted for a revenue
increase of approximately 1%.
The segment had operating income of $3.0 and $5.1 in the three and six months
ended September 24, 2004, respectively, as compared to operating losses of $10.7
and $12.4 in the three and six months ended September 26, 2003, respectively.
During Fiscal 2005, the segment benefited from savings realized from headcount
and cost reductions implemented during Fiscal 2004. The losses in Fiscal 2004
were driven primarily by higher R&D expenses, lower plant utilization, and asset
impairment and severance costs of $3.6 incurred in the second quarter of Fiscal
2004.
Consumer Communications
Three Months Ended Six Months Ended
-------------- -------------- ------------- --------------
Sept. 24, Sept. 26, Sept. 24, Sept. 267,
(millions of U.S. dollars) 2004 2003 2004 2003
-------------- -------------- ------------- --------------
Revenue $ 20.6 $ 13.8 $ 39.8 $ 27.2
============== ============== ============= ==============
As a % of total revenue 35% 29% 35% 27%
============== ============== ============= ==============
Operating loss $ (1.8) $ (6.6) $ (3.8) $ (11.1)
============== ============== ============= ==============
Zarlink's Consumer Communications products allow users to connect to the
network. These products include wireless (for example, cellular chipsets) and
infotainment applications (for example, terrestrial and satellite set-top boxes
and digital TV).
During the second quarter of Fiscal 2005, revenue increased 49% over the second
quarter of Fiscal 2004, to $20.6. Revenue in the six months ended September 24,
2004 totaled $39.8, an increase of 46% over the same period of Fiscal 2004.
Revenue improvements were driven primarily by increased sales volumes of the
Company's demodulators.
The segment had an operating loss of $1.8 in the three month period ended
September 24, 2004, as compared to $6.6 in the same period of Fiscal 2004. The
segment's operating loss during the first six months of Fiscal 2005 decreased to
$3.8, down $7.3 from the same period of Fiscal 2004. These improvements were
driven primarily by revenue improvements as well as savings realized from cost
reduction activities implemented during Fiscal 2004. The operating loss in the
three and
17
six month periods ended September 26, 2003 included asset impairment and other
costs of $1.9, and R&D specific severance costs of $0.2 incurred in the second
quarter of Fiscal 2004.
Ultra Low-Power Communications
Three Months Ended Six Months Ended
---------------------------------------------------
Sept. 24, Sept. 26, Sept. 24, Sept. 26,
(millions of U.S. dollars) 2004 2003 2004 2003
------------ ----------- ------------- ----------
Revenue
$ 11.3 $ 7.8 $ 22.0 $ 18.8
============ =========== ============ ==========
As a % of total revenue 19% 17% 19% 19%
Operating loss $ (1.0) $ (2.0) $ (1.5) $ (1.0)
============ =========== ============ ==========
Zarlink's Ultra Low-Power Communications business provides ASIC and ASSP
solutions for applications such as cardiac pacemakers, hearing aids, portable
instruments, electronic shelf labels, and personal area communications devices.
Revenue for the second quarter of Fiscal 2005 totaled $11.3, an increase of 45%
from the second quarter of Fiscal 2004. Revenue improvements were seen in the
segment's wireless and medical instruments product lines, which accounted for
approximately 27% and 23% of the revenue increase. These improvements were
partially offset by a decline in sales in the audiologic product line, which
accounted for a decrease of 5% of revenue. During the first six months of Fiscal
2005, revenue increased 17% over the same period in Fiscal 2004, to $22.0.
Revenue increases were due mainly to increased sales volumes of wireless
products.
For the three months ended September 24, 2004, the segment had an operating loss
of $1.0 as compared to $2.0 in the three months ended September 26, 2003.
Improvements were driven primarily by revenue increases. In addition, the
operating loss in the second quarter of Fiscal 2004 included asset impairment
and other costs of $0.4 and $0.2 of severance costs. The segment had an
operating loss of $1.5 in the first six months of Fiscal 2005 due to increased
spending, primarily in R&D. In comparison, the Company incurred an operating
loss of $1.0 in the same period of Fiscal 2004, due mainly to the asset
impairment and severance costs incurred in the second quarter of Fiscal 2004.
GEOGRAPHIC REVENUE
Revenue, based on the geographic location of customers, was distributed as
follows:
Three Months Ended Six Months Ended
------------------------------------------------------------------------------------------------------
(millions of U.S. Sept. 24, % of Sept. 26, % of Sept. 24, % of Sept. 26, % of
dollars) 2004 Total 2003 Total 2004 Total 2003 Total
------------------------------------------------------------------------------------------------------
Revenue:
Asia / Pacific $ 24.0 41% $17.7 38% $ 48.0 42% $40.2 40%
Europe 18.4 31% 13.7 29% 34.4 30% 30.5 30%
United States 13.0 22% 10.6 23% 24.6 21% 22.9 23%
Canada 2.4 4% 2.3 5% 4.5 4% 3.9 4%
Other Regions 1.0 2% 2.3 5% 3.1 3% 2.8 3%
------------------------------------------------------------------------------------------------------
Total $ 58.8 100% $46.6 100% $114.6 100% $100.3 100%
======================================================================================================
Asia/Pacific
Asia/Pacific revenue increased by 36% during the second quarter of Fiscal 2005
compared to the second quarter of Fiscal 2004, and continues to represent the
largest geographic segment of customer revenues. During the first six months of
Fiscal 2005, revenue in the Asia/Pacific region increased by 19% compared to the
same period in Fiscal 2004. The revenue increases in Fiscal 2005 were driven
primarily by increased shipments of the Company's demodulators.
18
Europe
European revenues increased by 34% in the second quarter of Fiscal 2005 compared
to the second quarter of Fiscal 2004. In the first six months of Fiscal 2005,
revenue increased by 13% compared to the same period of Fiscal 2004.
Improvements were driven primarily by increased shipments of electronic shelf
labels within the Ultra Low-Power Communications segment.
United States
Revenue to customers in the United States increased by 23% during the second
quarter of Fiscal 2005 compared to the second quarter of Fiscal 2004. In the
first six months of Fiscal 2005, revenue increased by 7% compared to the same
period of Fiscal 2004. The increases were due primarily to higher revenues
within the Network Communications segment.
Canada
Canadian revenue in the second quarter of Fiscal 2005 increased by $0.1 compared
to the same period in Fiscal 2004. For the first six months of Fiscal 2005,
revenue increased by 15% as compared to the first six months of Fiscal 2004,
primarily due to higher specialty product revenue within the Network
Communications segment.
Other
Revenue to customers in other regions decreased by $1.3 during the second
quarter of Fiscal 2005 compared to the second quarter of Fiscal 2004. The
decreases were due primarily to lower wireless product revenues within the
Consumer Communications segment. In the first six months of Fiscal 2005, revenue
increased by $0.3 as compared to the same period in Fiscal 2004. Strong sales of
wireless products within the Consumer Communications segment in the first
quarter of Fiscal 2005 contributed to the revenue increase.
GROSS MARGIN
Three Months Ended Six Months Ended
-------------------------------- -------------------------------
(millions of U.S. dollars) Sept. 24, 2004 Sept. 26, 2003 Sept. 24, 2004 Sept. 26, 2003
-------------- -------------- -------------- --------------
Gross Margin $ 26.8 $ 19.4 $ 52.0 $ 45.0
As a percentage of revenue 46% 42% 45% 45%
Gross margin in the second quarter of Fiscal 2005 was 46%, an increase of four
percentage points from the same period in Fiscal 2004. The increase in Fiscal
2005 was due primarily to savings realized from the cost reduction activities
implemented during Fiscal 2004, as well as savings generated from higher plant
utilization in Fiscal 2005. In the second quarter of Fiscal 2004, the Company
incurred approximately $0.6 of severance costs related to the restructuring
activities implemented in the period.
Gross margin in the six months ended September 24, 2004 of 45% was unchanged
from the same period in Fiscal 2004. Fiscal 2004 margins were unfavorably
impacted by $0.7 of severance costs incurred as part of the Company's cost
reduction efforts. Gross margin improvements in the first six months of Fiscal
2005 were driven by savings realized from the Fiscal 2004 cost reduction
activities. These improvements were partially offset by an unfavorable product
mix. Products within the Company's Consumer Communications segment generally
have lower margins than products in the Company's other business segments, and
increased revenue in this segment has decreased overall margins.
19
OPERATING EXPENSES
Research and Development ("R&D")
Three Months Ended Six Months Ended
-------------------------------- -------------------------------
(millions of U.S. dollars) Sept. 24, 2004 Sept. 26, 2003 Sept. 24, 2004 Sept. 26, 2003
-------------- -------------- -------------- --------------
R&D Expenses $ 15.6 $ 19.2 $ 30.5 $ 38.4
As a percentage of revenue 27% 41% 27% 38%
R&D expenses decreased by 19%, or $3.6, in the second quarter of Fiscal 2005
from the same period in Fiscal 2004. In the first six months of Fiscal 2005, R&D
expenses were $30.5, a decrease of 21% as compared to the same period in Fiscal
2004. The decreases resulted mainly from savings generated as a result of
headcount reductions and other cost reduction activities implemented during
Fiscal 2004. During the second quarter of Fiscal 2004, the Company reduced its
R&D headcount by 147 employees. The Company continues to refocus its R&D
resources on programs and products that demonstrate superior potential for near
and medium-term revenue.
In the Network Communications business segment, R&D activities focused on the
following areas:
o Network Timing and Synchronization - Digital and Analog Phase Lock
Loops (PLL) solutions for T1/E1 to SONET/SDH equipment requiring
accurate and standards driven timing and synchronization;
o TDM over Internet Protocol (IP) Processing Solutions - Meeting
network convergence with TDM over IP processing solutions for
applications requiring Circuit Switched Traffic over Packet Domains;
o Packet Switching - Fast Ethernet (FE) to Gigabit Ethernet (GbE)
switching for communication backplanes and linecards;
o Voice Processing Solutions - Low, medium and high-density voice echo
cancellation solutions meeting G.168 standards for wireless, wired
and enterprise segments;
o Time Division Multiplex (TDM) Switching - Solutions to set new
industry standards for channel density, levels of integration,
feature sets and power density for enterprise, edge and metro
segments; and
o Receivers and transmitters for single mode fiber (SMF) targeting the
access network as well as various applications where customization
is required.
In the Consumer Communications business segment, R&D activities focused on the
following areas:
o Providing tuner, demodulator and peripheral chips for satellite,
cable and terrestrial digital set-top boxes, integrated digital
televisions and adapter boxes; and
o Development of the most highly integrated system-on-a-chip solution
for integrated Digital Terrestrial Televisions, Digital Terrestrial
Set-top boxes, adapter boxes and media centers, compliant with the
Digital Video Broadcasting - Terrestrial (DVB-T) standard.
In the Ultra Low-Power Communications business segment, R&D activities focused
on semiconductor solutions and technologies for a variety of applications where
ultra low power consumption is an important differentiating feature, including:
o More application-specific standard products (ASSPs) as opposed to
custom products;
o Surge protection ASSPs used in implantable pacemakers and
defibrillators for cardiac rhythm management;
o High performance custom Coder/Decoders (CODECs) chips for major
hearing aid companies;
20
o Ultra low-power integrated circuits supporting short-range wireless
communications for industrial applications such as electronic shelf
labels, and healthcare applications such as implantable devices and
swallowable camera capsules; and
o High performance, ultra low-power audio data converter ASSPs,
intended for use in digital microphones, for high growth
communications and entertainment applications.
Selling and Administrative ("S&A")
Three Months Ended Six Months Ended
-------------------------------- -------------------------------
(millions of U.S. dollars) Sept. 24, 2004 Sept. 26, 2003 Sept. 24, 2004 Sept. 26, 2003
-------------- -------------- -------------- --------------
S&A Expenses $ 11.0 $ 14.2 $ 21.7 $ 25.8
As a percentage of revenue 19% 30% 19% 26%
S&A expenses decreased by 23%, or $3.2, in the second quarter of Fiscal 2005
from the same period in Fiscal 2004. For the six months ended September 24,
2004, S&A expense was $21.7, a decrease of 16% over the first six months of
Fiscal 2004. The Company reduced its headcount within sales, marketing, and
other administrative functions in France, Canada, and various other geographic
regions in Fiscal 2004. These headcount reductions resulted in severance costs
of $1.8 in the second quarter of Fiscal 2004. These costs as well as other cost
reduction activities implemented during Fiscal 2004 resulted in a reduction of
S&A expense in Fiscal 2005.
Stock Compensation
The Company records stock compensation expense arising from certain stock
options subjected to option exchange programs and from stock options awarded to
former employees. During the six months ended September 24, 2004, the Company
recorded stock compensation expense of $0.1, (2003 - nil), representing
amortization of the fair value of stock options awarded to a former employee.
Stock compensation expense was recorded as a component of S&A expense during the
period.
Gain on Sale of Business
During Fiscal 2002, the Company sold its wafer fabrication facility in Plymouth,
U.K., as well as certain intellectual property and related foundry businesses to
companies controlled by X-FAB Semiconductor Foundries AG (X-FAB) of Erfurt,
Germany for $30.0, represented by $12.0 in cash on closing and a note of $18.0
repayable over three years. At the time of the sale, the gain on sale was
deferred and netted against the carrying value of the note receivable. The
Company recognizes the gain as payments are made on the note receivable.
Based upon the terms of the Plymouth Foundry sale agreement with X-FAB, payment
of the note receivable was scheduled to occur in two installments of $10.0 and
$8.0. During the first quarter of Fiscal 2005, X-FAB exercised its option to
make early payments totaling $7.0 against the $10.0 installment due in the
second quarter of Fiscal 2005. The note receivable was discounted by $0.1 as a
result of the early payment. During the second quarter of Fiscal 2005, the
Company received a payment of $2.9 from X-FAB, to settle the installment due at
that time. As a result of these payments, in the three and six month periods
ended September 24, 2004, the Company recognized a gain on sale of business of
$2.9 and $9.9, respectively.
The final installment payment of $8.0 is due from X-FAB in the first quarter of
Fiscal 2006.
NON-OPERATING INCOME AND EXPENSE
Interest Income
Interest income was $0.2 for the three months ended September 24, 2004 as
compared to $0.3 in the same period of Fiscal 2004. During the first six months
of Fiscal 2005, interest income was $0.4 as compared to $0.6 in the first six
months of Fiscal 2004. The decreases were mainly due to reduced average cash
balances in Fiscal 2005.
21
Foreign Exchange Gains and Losses
Foreign exchange losses in the second quarter of Fiscal 2005 amounted to $0.1 as
compared to gains of $0.1 for the same period in Fiscal 2004. During the six
months ended September 24, 2004, foreign exchange losses amounted to $0.4 as
compared to $0.9 for the six months ended September 26, 2003. Net foreign
exchange gains and losses were recorded on monetary assets and liabilities
denominated in currencies other than the U.S. dollar functional currency, and
according to month-end market rates.
Interest Expense
Interest expense was nil for the three months ended September 24, 2004 as
compared to $0.3 in the same period of Fiscal 2004. During the first six months
of Fiscal 2005, interest expense was nil as compared to $0.3 in the first six
months of Fiscal 2004.
INCOME TAXES
There was no income tax expense recorded for the second quarter of Fiscal 2005,
compared with a recovery of $0.3 for the corresponding period in Fiscal 2004.
During the six months ended September 24, 2004, an income tax recovery of $1.0
was recorded, compared with no recovery in the same period of Fiscal 2004. The
recovery of $1.0 related to the release of previously recognized provisions no
longer required as a result of settlements with tax authorities, in addition to
a recovery of $0.3 relating to income tax refunds received in excess of
provisions previously recorded, offset by income tax expense of $0.3.
The Company has a valuation allowance against its deferred tax assets at
September 24, 2004 of $184.0 (March 26, 2004 - $176.8). The increase relates
mainly to losses incurred, partially offset by temporary differences in the
Company's domestic and foreign operations. Based on historical taxable income
and uncertainties relating to future taxable income over the periods in which
the deferred tax assets are deductible, management has determined that it is not
more likely than not that the results of future operations will generate
sufficient taxable income to realize certain of its net deferred tax assets.
Management periodically reviews the Company's valuation allowance to determine
whether the overall tax estimates are reasonable. When management performs its
quarterly assessments of the valuation allowance, it may be determined that an
adjustment is required to the valuation allowance, which may have a material
impact on the Company's financial position and results of operations.
NET INCOME (LOSS)
The Company recorded net income, after preferred share dividends, of $2.7, or
$0.02 per share, in the second quarter of Fiscal 2005. This compares to a net
loss, after preferred share dividends, of $19.4, or $0.15 per share, in the same
period of Fiscal 2004. For the six month period ended September 24, 2004, net
income after preferred share dividends was $9.7, or $0.08 per share, as compared
to a net loss after preferred share dividends of $26.1, or $0.20 per share, in
the same period of Fiscal 2004.
The net income for the three and six month period ended September 24, 2004, was
primarily a result of the gain on sale of business of $2.9 and $9.9,
respectively, as well as improved results due to improved revenues and margins
and operating expense savings realized from the cost reduction activities
implemented during Fiscal 2004.
LIQUIDITY AND CAPITAL RESOURCES
At September 24, 2004, the Company held cash and cash equivalents totaling $34.0
(March 26, 2004 - $27.0). In addition, the Company held short-term investments
of $47.2 at September 24, 2004 (March 26, 2004 - $54.8). The Company's
restricted cash balance at September 24, 2004 of $10.0 was unchanged from March
26, 2004.
Cash used in operating activities for the six months ended September 24, 2004
was $7.9, as compared to $17.7 used in the same period of Fiscal 2004. Cash
provided by operating activities before working capital changes amounted to $5.5
for the six months ended September 24, 2004, as compared to $11.4 used in the
first six months of Fiscal 2004. Cash provided by operations resulted primarily
from improved operating results during Fiscal 2005. Since March 26, 2004, the
Company's working capital increased by $13.4, mainly as a result of increases in
trade accounts receivable of $2.3, inventory of $3.7, prepaid expenses of $2.2,
other accounts receivable of $1.6, and decreases in accounts payable and accrued
liabilities totaling $3.2. The increase in trade accounts receivable was a
result of the timing of sales late in the quarter, resulting in the cash inflow
not occurring until the third quarter of Fiscal 2005. Inventory levels increased
to accommodate expected sales demand in upcoming quarters. Prepaid expenses
increased due primarily to the timing of
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payments on certain design tools. Other accounts receivable increases resulted
from claims with certain of the Company's foundry suppliers. Accounts payable
and accrued liabilities decreased primarily due to the timing of payments made
to the Company's foundry suppliers. In comparison, the Company's working capital
increased by $6.3 during the six months of Fiscal 2004, primarily as a result of
increases in accounts receivable and prepaid expenses resulting from the timing
of cash collections and payments during the quarter, partially offset by a
reduction in inventory.
Cash provided from investing activities was $15.9 for the six months ended
September 24, 2004, primarily from proceeds of $9.9 received as payment against
a note receivable from X-FAB. In addition, cash increased from the maturity of
short-term investments totaling $62.2, partially offset by purchases of
short-term investments totaling $54.6. Cash provided from investing activities
was $51.7 for the six months ended September 26, 2003, primarily from matured
short-term investments totaling $129.4, partially offset by purchases of
short-term investments of $75.1. Cash used in financing activities during the
first six months of Fiscal 2005 was $1.1. The use of cash was primarily the
result of the payment of $1.0 for dividends on the preferred shares. Cash used
in financing activities during the first six months of Fiscal 2004 was $1.3,
resulting primarily from payment of $1.0 for dividends on the preferred shares,
and the repurchase of $0.5 of the Company's redeemable preferred shares,
partially offset by a decrease in restricted cash of $0.6.
During Fiscal 2002, the Company took steps to wind up its defined benefit
pension plan in the United Kingdom and replaced it with a defined contribution
plan. The Company expects to make a final payment of approximately $2.5 later in
Fiscal 2005 after the final adjustments are determined. This amount was included
in other accrued liabilities as at September 24, 2004.
During the first six months of Fiscal 2005, the Company declared and paid
dividends of $1.0 on its redeemable preferred shares based on a quarterly
dividend of $0.38 (Cdn $0.50) per share dividend. During the six months ended
September 24, 2004, there were no preferred shares purchased by the Company, and
13,200 preferred shares cancelled. These cancelled preferred shares had been
repurchased during Fiscal 2004.
In addition to the Company's cash, cash equivalents, short-term investment and
restricted cash balances, the Company has a credit facility of $10.0 available
for letters of credit. Prior to the second quarter of Fiscal 2005, a credit
facility in Canadian dollars was available. During the second quarter of Fiscal
2005, the facility agreement was amended to reflect the limit in U.S. dollars,
to better reflect the nature of the Company's activities. As at September 24,
2004, cash and cash equivalents totaling $9.5 were hypothecated under the credit
facility to cover outstanding letters of credit. Of this amount, $8.0 was issued
to secure letters of credit related to the Company's pension plan in Sweden, and
$0.7 letters of credit were outstanding related to the Company's SERP. In
addition, $0.8 was issued to secure certain obligations under a performance
guarantee and office lease arrangement. The Company has also pledged $0.5 as a
security for a custom bond and related credit facilities. The credit facilities
are subject to periodic review, including the determination of compliance with
certain financial covenants. It is uncertain if the Company will be able to meet
these financial covenants in the future and, if not, to obtain a waiver from the
bank, which may result in the availability of the credit facility being reduced
or restricted. Management does not anticipate that this would have a material
adverse effect on the financial position of the Company. Management believes the
Company is in a position to meet all foreseeable business cash requirements and
capital lease and preferred share payments from its cash balances on hand,
existing financing facilities and cash flow from operations.
The Company's liquidity is impacted by contractual obligations. The Company's
wafer supply agreements stipulate wafer pricing based upon quantities ordered.
Although these agreements do not have minimum unit volume purchase requirements,
one of the Company's supply agreements contains contractual obligations in the
event of an order cancellation. This agreement states that if the Company
decreases the total quantity of an order containing fixed price and quantity,
the Company is committed to a higher fixed unit price for those wafers purchased
on that order. In this situation, the overall obligation is dependent upon the
volume and type of wafers purchased, and the remaining purchase period of this
pricing agreement. Based upon the number of wafers purchased to date under this
agreement, as at September 24, 2004, the maximum value of the price adjustment
is $0.4.
There have been no other significant changes to the Company's contractual
obligations included in Item 7, Management's Discussion and Analysis of
Financial Condition and Results of Operations, of the Company's Annual Report on
Form 10-K for the year ended March 26, 2004.
BACKLOG
The Company's 90-day backlog as at September 24, 2004 was $36.6 (June 25, 2004 -
$44.1). Generally, manufacturing lead times for semiconductor products are
longer because of the nature of the production process. However, as orders are
sometimes booked and shipped within the same fiscal quarter (often referred to
as "turns"), order backlog is not necessarily indicative of a sales outlook for
the quarter or year. Backlog decreased from the prior quarter due to decreased
bookings within all business segments. The most significant backlog decline was
seen in the Network Communications segment.
23
OTHER
Critical Accounting Policies and Significant Estimates
The Company's consolidated financial statements are based on the selection and
application of significant accounting policies, which require management to make
significant estimates and assumptions. There is no change in the Company's
critical accounting policies included in Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations, of the Company's
Annual Report on Form 10-K for the year ended March 26, 2004.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk
Market risk represents the risk of loss that may impact the financial statements
of the Company due to adverse changes in financial market prices and rates.
Zarlink is exposed to market risk from changes in foreign exchange and interest
rates. To manage these risks, the Company uses certain derivative financial
instruments including foreign exchange forward contracts and other derivative
instruments from time to time, which have been authorized pursuant to
board-approved policies and procedures. Zarlink does not hold or issue financial
instruments for trading or speculative purposes.
The Company currently uses forward contracts, and to a lesser extent foreign
currency options, to reduce the exposure to foreign exchange risk. The most
significant foreign exchange exposures for the Company relate to the U.K. pound
sterling, Canadian dollar, and the Swedish Krona. The change in market value of
the derivatives resulted in an unrealized loss of $0.1. Management believes that
the established hedges are effective against its known and anticipated cash
flows, and that potential future losses from these hedges being marked to market
would be largely offset by gains on the underlying hedged transactions.
The Company's primary exposure to interest rates is expected to be in the
rollover of its short-term investment portfolio. In accordance with Company
policy, cash equivalents and short-term investment balances are primarily
comprised of high-grade money market instruments with original maturity dates of
less than one year. The Company does not hedge the re-investment risk on its
short-term investments.
Management does not foresee any significant changes in the strategies used to
manage foreign exchange and interest rate risks in the near future.
As at September 24, 2004, there were no material changes in information about
market risks as disclosed in the Company's Annual Report on Form 10-K for the
fiscal year ended March 26, 2004.
ITEM 4. CONTROLS AND PROCEDURES
The Company's management carried out an evaluation, with the participation of
its Chief Executive Officer and Chief Financial Officer, of the effectiveness of
the Company's disclosure controls and procedures as of September 24, 2004. Based
upon that evaluation, the Company's Chief Executive Officer and Chief Financial
Officer concluded that the Company's disclosure controls and procedures were
effective to ensure that information required to be disclosed by the Company in
reports that it files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported, within the time periods specified
in the rules and forms of the Securities and Exchange Commission.
There has not been any change in the Company's internal controls over financial
reporting in connection with the evaluation required by Rule 13a-15(d) under the
Exchange Act that occurred during the quarter ended September 24, 2004 that has
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.
24
PART II - OTHER INFORMATION
ITEM 5. OTHER INFORMATION
The Company has been made aware of certain bookkeeping and payroll work
performed in fiscal 2002 through 2004 by affiliates of its Independent
Registered Public Accounting Firm, Ernst & Young LLP (E&Y) in Taiwan and China
that has raised issues regarding E&Y's independence with respect to its
performance of audit services. In Fiscal 2002, E&Y's Taiwan affiliate
transferred severance payments to Zarlink employees on behalf of Zarlink's
Canadian office totaling approximately $28,300. In Fiscal 2003 and 2004 EY's
China affiliate performed bookkeeping services. These services are not permitted
under the auditor independence rules. The Company, its Audit Committee and Ernst
& Young have considered the impact the providing of these services may have had
on Ernst & Young's independence with respect to the Company and concluded there
has been no impairment of Ernst & Young's independence. The services were
administrative in nature and the associated fees over the period the services
were provided aggregated approximately $16,000. The services have been
discontinued.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
31.1 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant
To Section 302(a) of The Sarbanes-Oxley Act of 2002, President and
Chief Executive Officer
31.2 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant
To Section 302(a) of The Sarbanes-Oxley Act of 2002, Senior Vice
President of Finance and Chief Financial Officer
32.1 Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, President and Chief Executive Officer
32.2 Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, Senior Vice President of Finance and Chief Financial Officer
99.1 Selected Consolidated Financial Statements in U.S. Dollars and in
accordance with Canadian Generally Accepted Accounting Principles
99.2 Management's Discussion and Analysis of Financial Condition and
Results of Operations - Canadian Supplement
b) Reports on Form 8-K
Date of Filing Description
- --------------------------------------------------------------------------------
July 21, 2004 Item 12 - Press Release: "Financial Results for the
Fiscal 2005 First Quarter Ended June 25, 2004"
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant, Zarlink Semiconductor Inc., has duly caused this
report to be signed on its behalf by the undersigned, thereunto duly authorized.
Zarlink Semiconductor Inc.
(Registrant)
Name Title Date
- ------------------------------------------ ---------------------------------------- ----------------------------------------
/s/ SCOTT MILLIGAN
- ------------------------------------------
Scott Milligan Senior Vice President of Finance October 28, 2004
and Chief Financial Officer
(Principal Financial and Accounting
Officer)
25