UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-Q

 

(Mark One)

For the quarterly period ended November 29, 2019

OR

Commission File Number: 001-38102

 

SMART GLOBAL HOLDINGS, INC.

(Exact Name of Registrant as Specified in its Charter)

 

Registrant’s telephone number, including area code: (510) 623-1231

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

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  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

As of November 29, 2019, the registrant had 23,838,397 ordinary shares outstanding.

 

 

 

 

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Table of Contents

 

 

 

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Cautionary Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q includes a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that involve many risks and uncertainties. Forward-looking statements are identified by the use of the words “would,” “could,” “will,” “may,” “expect,” “believe,” “should,” “anticipate,” “if,” “future,” “intend,” “plan,” “estimate,” “potential,” “target,” “seek,” or “continue” and similar words and phrases, including the negatives of these terms, or other variations of these terms, that denote future events. These statements reflect our current views with respect to future events and our potential financial performance and are subject to risks and uncertainties that could cause our actual results and financial position to differ materially and adversely from what is projected or implied in any forward-looking statements included in this report. These factors include, but are not limited to, the risks described under the caption “Risk Factors” in the documents we file from time to time with the Securities and Exchange Commission, including in our Annual Report on Form 10-K for our fiscal year ended August 30, 2019, and in this report, and in Item 2 of Part I – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this report may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. We make these forward-looking statements based upon information available on the date of this report, and we expressly disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information or otherwise, except as required by law.

 

 

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

SMART Global Holdings, Inc.

and Subsidiaries

Condensed Consolidated Balance Sheets

(In thousands, except per share data)

(Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

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SMART Global Holdings, Inc. and Subsidiaries

Condensed Consolidated Income Statements

(In thousands, except per share data)

(Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

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SMART Global Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Comprehensive Income (Loss)

(In thousands)

(Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

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SMART Global Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Equity

(In thousands)

(Unaudited)

 

 

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

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SMART Global Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

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Smart Global Holdings, Inc.

Notes to Unaudited Condensed Consolidated Financial Statements

Note 1. Basis of Presentation and Principles of Consolidation

On August 26, 2011, SMART Global Holdings, Inc., formerly known as Saleen Holdings, Inc., a Cayman Islands exempted company (SMART Global Holdings, and together with its subsidiaries, the Company), consummated a transaction with SMART Worldwide Holdings, Inc., formerly known as SMART Modular Technologies (WWH), Inc. (SMART Worldwide), pursuant to an Agreement and Plan of Merger whereby, through a series of transactions, SMART Global Holdings acquired substantially all of the equity interests of SMART Worldwide with SMART Worldwide surviving as an indirect wholly owned subsidiary of SMART Global Holdings (the Acquisition). SMART Global Holdings is an entity that was formed by investment funds affiliated with Silver Lake Partners and Silver Lake Sumeru (collectively Silver Lake). As a result of the Acquisition, since there was a change of control resulting in Silver Lake as the controlling shareholder group, the Company applied the acquisition method of accounting and established a new basis of accounting.

The Company, through its subsidiaries, are leading designers and manufacturers of electronic products focused on memory and computing technology areas. The Company specializes in application specific product development and support for customers in enterprise, government and OEM markets. Customers rely on SMART as a strategic supplier with top tier customer service, product quality, and technical support with engineering, sales, manufacturing, supply chain and logistics capabilities worldwide. The Company targets customers in markets such as communications, storage, networking, mobile, industrial automation, industrial internet of things, government, military, edge computing and high performance computing.  The Company operates in three segments: Specialty Memory Products, Brazil Products and Specialty Compute and Storage Solutions, or SCSS.

SMART Global Holding is domiciled in the Cayman Islands and has U.S. headquarters in Newark, California. The Company has operations in the United States, Brazil, Malaysia, Taiwan, Hong Kong, Scotland, Singapore, India, Netherlands and South Korea.

The accompanying condensed consolidated financial statements comprise SMART Global Holdings and its wholly owned subsidiaries. Intercompany transactions have been eliminated in the condensed consolidated financial statements.

The Company uses a 52- to 53-week fiscal year ending on the last Friday in August. The three months ended November 29, 2019 and November 30, 2018 were both 13 week fiscal periods.

The accompanying unaudited condensed consolidated financial statements and related notes have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) and in conformity with the rules and regulations of the Securities and Exchange Commission (SEC) applicable to interim financial information. As such, certain information and footnote disclosures normally included in complete annual financial statements prepared in accordance with U.S. GAAP have been omitted in accordance with the rules and regulations of the SEC. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal recurring accruals, necessary to present fairly the financial position of the Company and its results of operations and cash flows for the interim periods presented. The financial data and other information disclosed in these notes to the condensed consolidated financial statements related to the interim periods are unaudited.

All financial information for two of the Company’s subsidiaries, SMART Modular Technologies Indústria de Componentes Eletrônicos Ltda. (SMART Brazil) and SMART Modular Technologies do Brasil Indústria e Comércio de Componentes Ltda. (SMART do Brazil), is included in the Company’s condensed consolidated financial statements on a one-month lag because their fiscal years begin August 1 and end July 31.

The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods presented. Actual results could differ from the estimates made by management. Significant items subject to such estimates and assumptions include the useful lives of long-lived assets, the valuation of deferred tax assets and inventory, share-based compensation, the estimated net realizable value of Brazilian tax credits, income tax uncertainties and other contingencies.

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The Company’s revenues include products and services. The Company’s product revenues are predominantly derived from the sale of memory modules, flash memory cards, compute products and storage products, which the Company designs and manufactures. The Company’s service revenues are derived from procurement, logistics, inventory management, temporary warehousing, kitting and packaging services. Also, a small portion of the Company’s product sales include extended warranty and on-site services, subscriptions to the Company’s high performance computing environment, professional services, software and related support.

The Company determines revenue recognition through the following steps: (1) identification of the contract with a customer; (2) identification of the performance obligations in the contract; (3) determination of the transaction price; (4) allocation of the transaction price to the performance obligations in the contract; and (5) recognition of revenue when, or as, a performance obligation is satisfied.

The Company’s contracts are executed through a combination of written agreements along with purchase orders with all customers including certain general terms and conditions. Generally, purchase orders entail products, quantities and prices, which define the performance obligations of each party and are approved and accepted by the Company. The Company’s contracts with customers do not include extended payment terms. Payment terms vary by contract type and type of customer and generally range from 30 to 45 days from invoice. Additionally, taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer and deposited with the relevant government authority, are excluded from revenue.

The transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring goods or services to the customer adjusted for estimated variable consideration.  Variable consideration may include discounts, rights of return, refunds, and other similar obligations. The Company allocates the transaction price to each distinct product and service based on its relative standalone selling price. The standalone selling price for products primarily involves the cost to produce the deliverable plus the anticipated margin and for services is estimated based on the Company’s approved list price.

In the normal course of business, the Company does not accept product returns unless the items are defective as manufactured. The Company establishes provisions for estimated returns and warranties. In addition, the Company does not typically provide customers with the right to a refund and does not transact for noncash consideration.

Standard Products

The Company’s main performance obligations are to deliver the requested goods to customers according to the agreed-upon shipping terms. The Company recognizes revenue when control transfers to the customer (i.e., when the Company’s performance obligation is satisfied). The Company invoices the customer and recognizes revenues for such delivery when control has transferred based on shipping terms.

Customized Products

For customized product sales with terms that require the customer to purchase 100% of all parts built to fulfill the customers forecast, the Company recognizes revenue when control of the underlying assets passes to the customer, as the customer is able to both direct the use of, and obtain substantially all of the remaining benefit from the assets; the customer has the significant risks and rewards associated with ownership of the assets; and the Company has a present right to payment. For these sales, control passes when the Company has made these products available to the customer and under the terms of the agreement cannot repurpose them without the customer’s express consent.  Accordingly, the Company will recognize revenue at the point in time when products made to the customer’s forecast are completed and made available to the customer.

Non-cancellable nonrefundable, or NCNR, customized product sales are recognized over time on a cost incurred basis. The customer obtains control and benefits from the services as they are performed over the period based on the cost input measure in the production process for the NCNR customized product. The terms within the NCNR sales orders provide the Company with a legally enforceable right to receive payment including a reasonable profit margin upon customer cancellation for performance completed to date. Accordingly, the Company recognizes revenue over time as customized products listed within the NCNR orders are completed.

Computing Products and Services

A small portion of the Company’s product sales includes extended warranty and on-site services, subscriptions to the Company’s high performance computing environment, professional consulting services including installation and other services, and hardware and software related support. Each contract may contain multiple performance obligations, which requires the transaction price to be allocated to each performance obligation. The Company allocates the consideration to each performance obligation based on the relative selling price. The Company uses best-estimated selling price, determined as the best estimate of the price at which the Company would transact if it sold the deliverable regularly on a stand-alone basis.  

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For services provided to the customers over a period of time, such revenues are recognized over time in line with when the customer receives and consumes the benefit of the services. Extended warranty and on-site services, hardware support, software support, and subscription revenue for access to the Company’s high performance computing environment is deferred and recognized ratably over the contractual period as the Company transfers control as it satisfies its performance obligations over time as the services are rendered.  These services contracts are typically one to three years in length. Subscription revenue for certain customers is recognized based on the contractual fee to use the high-performance-computing environment.  Professional consulting services revenue is recognized as the service is performed and the customer obtains control and benefits from the services as they are performed over the period.  The methods of recognizing revenue for each of these products and services were selected because they reflect a faithful depiction of the transfer of control.

Agency Services

The Company has service performance obligations for agency related services such as procurement, logistics, inventory management, temporary warehousing, kitting and packaging services for certain agency basis customers. The agency services are also known as supply chain services and the performance obligations for these services consist of customized, integrated supply chain services management to assist customers in the planning, execution and overall management of the procurement processes.

For these customers that are accounted for on an agency basis, the Company recognizes as revenue the amount billed less the material procurement costs of products serviced as an agent with the cost of providing these services embedded with the cost of sales. The Company has separate agent performance obligations as follows: (a) procurement, logistics, and inventory management, (b) temporary warehousing, and (c) kitting and packaging services for these customers. Revenue from these arrangements is recognized as service revenue and is determined by a fee for services based on material procurement costs (i.e. fee as a percentage of the associated material being procured, warehoused, kitted or packaged). The Company recognizes revenue for procurement, logistics and inventory management upon the completion of the services or performance obligation, typically upon shipment of the product, as the criteria for over time recognition is not met.  For temporary warehousing, kitting and packaging services, revenue is recognized over time, but the period of performance is typically very short in duration. There are no obligations subsequent to shipment of the product under the agency arrangements.

Contract Costs

As a practical expedient, the Company recognizes the incremental costs of obtaining a contract, specifically commission expenses that have an amortization period of less than twelve months, as an expense when incurred. Additionally, the Company has adopted an accounting policy to recognize shipping costs that occur after control transfers, if any, to the customer as a fulfillment activity. The Company records shipping and handling costs related to revenue transactions within cost of sales as a period cost.

Gross Billings and Net Sales

The following is a summary of the Company’s gross billings to customers and net sales for services and products (in thousands):

 

 

 

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Contract Balances

The Company records accounts receivable when it has an unconditional right to consideration. Contract assets represent amounts recognized as revenue for which the Company does not have the unconditional right to consideration. All contract assets represent amounts related to invoices expected to be issued during the next 12-month period and are recorded as prepaid expenses and other current assets. Contract liabilities are recorded when cash payments are received or due in advance of performance. Contract liabilities consist of advance payments and deferred revenue, where the Company has unsatisfied performance obligations. Contract liabilities are classified as deferred revenue and are allocated between accrued liabilities and other long-term liabilities of our condensed consolidated balance sheet based on the timing of when the customer takes control of the asset or receives the benefit of the service. Payment terms vary by customer. The time between invoicing and when payment is due is not significant. Changes in the accounts receivable, contract assets and the deferred revenues balances during the three months ended November 29, 2019 are as follows (in thousands):

 

 

The decrease in contract assets from $4.6 million as of August 30, 2019 to $0.9 million as of November 29, 2019 was primarily driven by the completion of performance obligations. The increase in deferred revenue from $24.2 million to $24.7 million was due to additional funds collected for hosting and support contracts signed during the quarter in which billing occurred in advance of revenue recognition. During the three months ended November 29, 2019, $5.0 million of revenue recognized was included in the deferred revenue balance at the beginning of the period, which was offset by additional deferrals during the period.

Disaggregation of Revenue

The Company disaggregates revenue by source of revenue and geography; no other level of disaggregation is required considering the type of products, customer, markets, contracts, duration of contracts, timing of transfer of control, and sales channels. The revenue by source and geography is disclosed in Note 11.

Revenue Allocated to Remaining Performance Obligations

The Company’s performance obligations related to product sales have a contractual duration of less than one year. The Company elected to apply the optional exemption practical expedient provided in ASC 606 and, therefore, is not required to disclose the aggregate amount of the transaction price allocated to those performance obligations that are unsatisfied or partially unsatisfied at the end of the reporting period.

Remaining performance obligations represent contracted revenue related to support services that have not yet been recognized. The Company expects to recognize revenue on the remaining performance obligations as follows (in thousands):

 

 

All highly liquid investments with maturities of 90 days or less from original dates of purchase are carried at cost, which approximates fair value, and are considered to be cash. Cash and cash equivalents include cash on hand, cash deposited in checking and saving accounts, money market accounts, and securities with maturities of less than 90 days at the time of purchase. Due to the adoption of ASU 2016-18 in fiscal 2019, the presentation of the Statement of Cash Flows has been updated with the inclusion of restricted cash – refer to Note 1(u) for details.

The Company evaluates the collectability of accounts receivable based on a combination of factors. In cases where the Company is aware of circumstances that may impair a specific customer’s ability to meet its financial obligations, the Company records a specific allowance against amounts due and, thereby, reduces the net recognized receivable to the amount management

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reasonably believes will be collected. For all other customers, the Company recognizes allowances for doubtful accounts based on a combination of factors including the length of time the receivables are outstanding, industry and geographic concentrations, the current business environment and historical experience.

The Company records the assets or liabilities associated with derivative instruments at fair value based on Level 2 inputs in other current assets or other current liabilities, respectively, in the condensed consolidated balance sheets. The accounting for gains and losses resulting from changes in fair value depends on the use of the derivative and whether it is designated and qualifies for hedge accounting. See Note 4 for further details.

Inventories are valued at the lower of actual cost or net realizable value. Inventory value is determined on a specific identification basis for material and an allocation of labor and manufacturing overhead. At each balance sheet date, the Company evaluates the ending inventories for excess quantities and obsolescence. This evaluation includes an analysis of sales levels by product family and considers historical demand and forecasted demand in relation to the inventory on hand, competitiveness of product offerings, market conditions and product life cycles. The Company adjusts carrying value to the lower of its cost or net realizable value. Inventory write-downs are not reversed and create a new cost basis.

Since 2004, the Sao Paulo State tax authorities have granted SMART Brazil a tax benefit to defer and eventually eliminate the payment of ICMS levied on certain imports from independent suppliers. This benefit, known as an ICMS Special Regime, is subject to renewal every two years. When the then current ICMS Special Tax Regime expired on March 31, 2010, SMART Brazil timely applied for a renewal of the benefit, however, the renewal was not granted until August 4, 2010.

On June 22, 2010, the Sao Paulo authorities published a regulation allowing companies that applied for a timely renewal of an ICMS Special Regime to continue utilizing the benefit until a final conclusion on the renewal request was rendered. As a result of this publication, SMART Brazil was temporarily allowed to utilize the benefit while it waited for its renewal. From April 1, 2010, when the ICMS benefit lapsed, through June 22, 2010 when the regulation referred to above was published, SMART Brazil was required to pay the ICMS taxes on imports, which payments result in ICMS credits that may be used to offset ICMS obligations generated from sales by SMART Brazil of its products; however, the vast majority of SMART Brazil’s sales in Sao Paulo were either subject to a lower ICMS rate or were made to customers that were entitled to other ICMS benefits that enabled them to eliminate the ICMS levied on their purchases of products from SMART Brazil. As a result, from April 1, 2010 through June 22, 2010, SMART Brazil did not have sufficient ICMS collections against which to apply the credits and the credit balance increased significantly.

Effective February 1, 2011, in connection with its participation in a Brazilian government incentive program known as Support Program for the Technological Development of the Semiconductor and Display Industries Laws, or PADIS, SMART Brazil spun off the module manufacturing operations into SMART do Brazil, a separate subsidiary of the Company. In connection with this spin off, SMART do Brazil applied for a tax benefit from the State of Sao Paulo in order to obtain a deferral of state ICMS. This tax benefit is referred to as State PPB, or CAT 14. The CAT 14 approval was not obtained until July 21, 2011, and from February 1, 2011 until the CAT 14 approval was granted, SMART do Brazil did not have sufficient ICMS collections against which to apply the credits accrued upon payment of the ICMS on SMART do Brazil’s imports and inputs locally acquired, and therefore, it generated additional excess ICMS credits.

As of  November 29, 2019, the total ICMS tax credits reported on the Company’s accompanying condensed consolidated balance sheet are R$30.6 million (or $7.6 million), of which (i) R$5.3 million (or $1.3 million) are fully vested ICMS credits, classified as prepaid and other current assets and R$23.5 million (or $5.9 million) are fully vested ICMS credits, classified as other noncurrent assets, and (ii) R$1.8 million (or $0.4 million) are ICMS credits subject to vesting in 48 equal monthly amounts, classified as prepaid expenses and other current assets (R$0.6 million or $0.1 million) and other noncurrent assets (R$1.2 million or $0.3 million). As of August 30, 2019, the total ICMS tax credits reported on the Company’s accompanying condensed consolidated balance sheet are R$32.3 million (or $8.6 million), of which (i) R$7.2 million (or $1.9 million) are fully vested ICMS credits, classified as prepaid and other current assets and R$23.2 million (or $6.2 million) are fully vested ICMS credits, classified as other noncurrent assets, and (ii) R$1.9 million (or $0.5 million) are ICMS credits subject to vesting in 48 equal monthly amounts, classified as prepaid expenses and other current assets (R$0.6 million or $0.2 million) and other noncurrent assets (R$1.3 million or $0.3 million). It is expected that the excess ICMS credits will continue to be recovered in fiscal 2020 through fiscal 2023. The Company updates its forecast of the recoverability of the ICMS credits quarterly, considering the following key variables in Brazil: timing of government approvals of automated credit utilization, the total amount of sales, the product mix and the inter and intra state mix of sales. If these estimates or the mix of products or regions vary, it could take longer or shorter than expected to recover the accumulated ICMS credits, resulting in a reclassification of ICMS credits from current to noncurrent, or vice versa.

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In April and June 2016, the Company filed cases with the State of Sao Paulo tax authorities to seek approval to sell excess ICMS credits. In December 2017, the Company obtained approval to sell R$31.6 million (or $7.9 million) of its ICMS credits.  Once approved, sales of ICMS credits usually take three to six months to complete and typically incur a discount to the face amount of the credits sold, as well as fees for the arrangers of these sales which together aggregate 10% to 15% of the face amount of the credits being sold. Once the sale agreement is complete, the tax authorities usually approve the transfer of credits in monthly installments and the proceeds resulting from the sale of the aforementioned credits shall be received by the Company accordingly. The Company has recorded valuation adjustments for the estimated discount and fees that the Company will need to offer in order to sell the ICMS credits to other companies.

In the first quarter of fiscal 2019, the Company received the approval to sell R$17.7 million (or $4.4 million) of its ICMS credits. The payments are to be received in 22 installments starting in the second quarter of fiscal 2019 through fiscal 2020. The Company received a total of R$2.0 million (or $0.5 million) and R$10.0 million (or $2.5 million) of the monthly installments during three months ended November 29, 2019 and fiscal 2019.

Property and equipment are recorded at cost. Depreciation and amortization are computed based on the shorter of the estimated useful lives or the related lease terms, using the straight-line method. Estimated useful lives are presented below:

 

 

*Includes the land lease for the Penang facility with a term expiring in 2070.

The Company performs a goodwill impairment test annually during the fourth quarter of its fiscal year and more frequently if events or circumstances indicate that impairment may have occurred. Such events or circumstances may, among others, include significant adverse changes in the general business climate. As of November 29, 2019 and August 30, 2019, the carrying value of goodwill on the Company’s condensed consolidated balance sheet was $79.9 million and $81.4 million, respectively.

When conducting the annual impairment test for goodwill, the Company compares the estimated fair value of a reporting unit containing goodwill to its carrying value. If the fair value of the reporting unit is determined to be more than its carrying value, no goodwill impairment is recognized. The excess of the fair value of the reporting unit over the fair value of assets less liabilities is the implied value of goodwill and is used to determine the amount of impairment.

All of the $79.9 million carrying value of goodwill on the Company’s condensed consolidated balance sheet as of November 29, 2019 is associated with the Company’s three reporting segments (Specialty Memory Products, Brazil Products and SCSS). No impairment of goodwill was recognized through November 29, 2019.

The changes in the carrying amount of goodwill during the three months ended November 29, 2019 and fiscal 2019 are as follows (in thousands):

 

 

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The following table summarizes the gross amounts and accumulated amortization of intangible assets by type as of November 29, 2019 and August 30, 2019 (dollars in thousands):

 

 

Amortization expense related to intangible assets totaled approximately $3.4 million and $1.0 million during the three months ended November 29, 2019 and November 30, 2018, respectively. Acquired intangibles are amortized on a straight-line basis over the remaining estimated economic life of the underlying intangible assets.

 

 

Estimated amortization expense of these intangible assets for the next five fiscal years and all years thereafter are as follows (in thousands):

 

 

Long-lived assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset group to the future undiscounted cash flows expected to be generated by the asset group. If such assets are considered to be impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed are reported at the lower of the carrying amount or fair value, less cost to sell. No impairment of long-lived assets was recognized during the three months ended November 29, 2019 and November 30, 2018.

Research and development expenditures are expensed in the period incurred.

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The Company uses the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and net operating loss and credit carryforwards. When necessary, a valuation allowance is recorded to reduce tax assets to amounts expected to be realized. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income (or loss) in the period that includes the enactment date. The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. The Company records interest and penalties related to unrecognized tax benefits in tax expense.

For foreign subsidiaries using the local currency as their functional currency, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expenses are translated at average exchange rates during the period. The effect of this translation is reported in other comprehensive income (loss). Exchange gains and losses arising from transactions denominated in a currency other than the functional currency of the respective foreign subsidiaries are included in results of operations.

For foreign subsidiaries using the U.S. dollar as their functional currency, the financial statements of these foreign subsidiaries are remeasured into U.S. dollars using the historical exchange rate for property and equipment and certain other nonmonetary assets and liabilities and related depreciation and amortization on these assets and liabilities. The Company uses the exchange rate at the balance sheet date for the remaining assets and liabilities, including deferred taxes. A weighted average exchange rate is used for each period for revenues and expenses.

All foreign subsidiaries and branch offices, except those in Brazil and South Korea, use the U.S. dollar as their functional currency. The gains or losses resulting from the remeasurement process are recorded in other income (expense) in the accompanying condensed consolidated income statements.

During the three months ended November 29, 2019 and November 30, 2018, the Company recorded $0.9 million and $3.4 million, respectively, of foreign exchange losses primarily related to its Brazilian operating subsidiaries.

The Company accounts for share-based compensation under ASC 718, Compensation—Stock Compensation, which requires companies to recognize in their income statement all share-based payments, including grants of share options and other types of equity awards, based on the grant-date fair value of such share-based awards.

 

 

The Company is subject to the possibility of various loss contingencies arising in the ordinary course of business. The Company considers the likelihood of a loss and the ability to reasonably estimate the amount of loss in determining the necessity for and amount of any loss contingencies. Estimated loss contingencies are accrued when it is probable that a liability has been incurred or an asset impaired and the amount of loss can be reasonably estimated. The Company regularly evaluates the most current information available to determine whether any such accruals should be recorded or adjusted.

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Comprehensive income (loss) consists of net income (loss) and other gains and losses affecting shareholders’ equity that, under U.S. GAAP are excluded from net income (loss). The Company’s other comprehensive income (loss) generally consists of foreign currency translation adjustments.

The Company’s concentration of credit risk consists principally of cash and cash equivalents and accounts receivable. The Company’s revenue and related accounts receivable reflect a concentration of activity with certain customers (see Note 12). The Company does not require collateral or other security to support accounts receivable. The Company performs periodic credit evaluations of its customers to minimize collection risk on accounts receivable and maintains allowances for potentially uncollectible accounts.

The Company relies on three suppliers for the majority of its raw materials. At November 29, 2019 and August 30, 2019, the Company owed these three suppliers $136.2 million and $91.5 million, respectively, which was recorded as accounts payable and accrued liabilities. The inventory purchases from these suppliers during the three months ended November 29, 2019 and November 30, 2018 were $0.2 billion and $0.4 billion, respectively.

In October 2018, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2018-16, Derivatives and Hedging (Topic 815) Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes. This standard amends ASC 815, Derivatives and Hedges, and permits the SOFR OIS rate as an approved rate to be used in valuing derivative instruments. ASU 2018-16 is effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2018, on a prospective basis. The Company adopted this ASU 2018-16 in the current fiscal quarter with no impact to our condensed consolidated financial statements.

In February 2018, the FASB issued ASU No. 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Comprehensive Income. The new guidance allows companies to reclassify standard tax effects resulting from the Tax Act, from accumulated other comprehensive income to retained earnings. The guidance also requires certain new disclosures regardless of the election.  The Company is required to adopt the guidance in the first quarter of fiscal 2020. The Company adopted this ASU 2018-02 in the current fiscal quarter with no impact to our condensed consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), which modified lease accounting for both lessees and lessors to increase transparency and comparability by recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous accounting standards and disclosing key information about leasing arrangements, among other things. ASU 2016-02 is effective for annual reporting periods and interim periods within those years, beginning after December 15, 2018. Effective August 31, 2019, the Company adopted Topic 842, using the modified retrospective transition approach. The Company applied the new guidance to all leases existing as of the date of adoption. Our reported results for the first quarter of fiscal 2020 reflect the application of Topic 842, while prior period amounts have not been adjusted and continue to be reported in accordance with our historical accounting under Topic 840.

We elected the practical expedient package permitted under the transition approach. As such, we did not reassess whether any expired or existing contracts are or contain leases, we did not reassess our historical lease classification, and we did not reassess our initial direct costs for any leases that existed prior to August 31, 2019. We did not elect the use-of-hindsight. The new standard also provides practical expedients for an entity’s ongoing accounting. We elected the short-term lease recognition exemption. This means, for those leases that qualify, we will not recognize a right-of-use asset or lease liability. We also elected the practical expedient to not separate lease and non-lease components for all our leases.

As of the date of adoption, we recognized operating lease right-of-use assets of $24.3 million, with corresponding operating lease liabilities of $25.0 million on the condensed consolidated balance sheets. The difference between the operating lease right-of-use assets and operating lease liabilities primarily relates to deferred rent.

For further information regarding the impact of Topic 842 adoption, see Note 5 Balance Sheet Details.

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In May 2014, the FASB issued a new standard, ASU No. 2014-09, Revenue from Contracts with Customers, as amended, which supersedes nearly all existing revenue recognition guidance. The FASB has issued several amendments to the new standard, including clarification on identifying performance obligations. The amendments include ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606)—Principal versus Agent Considerations, which was issued in March 2016, and clarifies the implementation guidance for principal versus agent considerations in ASU 2014-09. The new standard permits adoption either by using (i) a full retrospective approach for all periods presented in the period of adoption or (ii) a modified retrospective approach with the cumulative effect of initially applying the new standard recognized at the date of initial application and providing certain additional disclosures. The new standard is effective for annual reporting periods beginning after December 15, 2017. The Company adopted the new standard effective September 1, 2018 using the modified retrospective approach applied to all contracts that are not completed contracts at the date of initial adoption (i.e. September 1, 2018).

 

 

Fiscal Year 2019

SMART Embedded Computing, Inc. (SMART EC)

On July 8, 2019, SMART Global Holdings entered into a Stock Purchase Agreement (the Artesyn SPA), by and among SMART Global Holdings, Artesyn Embedded Computing, Inc., a Wisconsin corporation (AEC), Pontus Intermediate Holdings II, LLC, a Delaware limited liability company, and Pontus Holdings LLC, a Delaware limited liability company. Pursuant to the Artesyn SPA, on July 8, 2019, the Company agreed to purchase all of the shares of AEC, a private company based in Tempe, Arizona and Artesyn Netherlands B.V., a company with limited liability organized under the laws of the Netherlands (AEC and Artesyn Netherlands B.V., collectively Artesyn), both entities being subsidiaries of Artesyn Embedded Technologies, Inc. SMART Global Holdings through one or more subsidiaries, paid the Artesyn equityholders a base purchase price of approximately $75 million at closing using cash on hand. Pursuant to the Artesyn SPA, the former equityholders of Artesyn are also entitled to earn-out  payments of up to $10 million based on Artesyn’s achievement of specific gross revenue levels through December 31, 2019 plus additional earn-out payments of $0.10 for each dollar of gross revenue through December 31, 2019 over an agreed upon achievement level. The earn-out is payable, at the option of the Company, in either cash or ordinary shares of SMART Global Holdings. SMART Global Holdings deposited $0.8 million of the purchase price into escrow as security for sellers’ indemnification obligations during the escrow period of one year. The Company changed the name of AEC to SMART Embedded Computing, Inc., or SMART EC.

Under the acquisition method of accounting, the assets acquired and liabilities assumed of SMART EC were recorded as of the acquisition date at their respective fair values. The reported consolidated financial condition after completion of the acquisition reflects these fair values. SMART EC’s results of operations are included in the consolidated financial statements from the date of acquisition.

The initial fair value of contingent consideration was estimated at the date of acquisition to be $2.7 million, which was recorded as a current liability. The Company determined the fair value of the obligations to pay contingent consideration using a real options technique which incorporates various estimates, including projected gross revenue for the period, a volatility factor applied to gross revenue based on year-on-year growth in gross revenue of comparable companies, discount rates and the estimated amount of time until final payment is made. This fair value measurement is based on significant inputs not observable in the market, which ASU 820-10-35 refers to as Level 3 inputs. The resulting probability-weighted cash flows were discounted using the Company’s estimated cost of debt of 8.50% derived from the Company’s interest rates from the existing line of credit (2.75% plus US Prime Rate) and its term loan (6.25% plus 3-month LIBOR).

Subsequent to the acquisition date, the Company adjusted the contingent consideration to its current fair value with such changes recognized in income from operations. Changes in fair values reflect new information about the probability and timing of meeting the conditions of the gross revenue target. As of November 29, 2019 and August 30, 2019, the fair value of the contingent consideration was $0.

A reconciliation of net cash exchanged in accordance with the Artesyn SPA to the total purchase price as of the closing date of the transaction, July 8, 2019, is presented below (in thousands):

 

 

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The total purchase consideration has been allocated to the tangible and intangible assets acquired and liabilities assumed. The assets acquired and liabilities assumed at the acquisition date are based upon their respective fair values summarized below (in thousands):

 

 

Asset categories acquired included working capital, fixed assets, and identified intangible assets. The intangible assets are as follows (in thousands):

 

 

The excess of purchase price over the fair value amounts assigned to the assets acquired and liabilities assumed represents the goodwill amount resulting from the acquisition. The Company does not expect any portion of this goodwill to be deductible for tax purposes. The goodwill attributable to the SMART EC acquisition has been recorded as a noncurrent asset and is not amortized but is subject to an annual review for impairment. Factors that contributed to the recognition of goodwill include the broader reach and capabilities of the Company into new technologies, markets and channels that leverage its existing products and services. SMART EC brings an outstanding customer base, solid products and strong supplier relationships to the Company in the defense, industrial IoT (IIoT), edge computing, and communications OEM markets. SMART EC will have substantially improved access to capital to drive additional investment in, and further development and growth of its products and services.

Due to the timing of acquisition, the total purchase consideration has been allocated to the tangible and intangible assets acquired and liabilities assumed based on a preliminary valuation analysis. These preliminary values may change in future reporting periods upon finalization of the valuation and net working capital adjustment, which will occur no later than the fourth quarter of fiscal 2020. During the three months ended November 29, 2019 and fiscal 2019, the Company incurred certain costs related to the acquisition, which are included in selling, general and administrative expense in the condensed consolidated statement of operations. Acquisition-related costs include the following (in thousands).

 

 

SMART Wireless Computing, Inc. (SMART Wireless)

On July 9, 2019, SMART Global Holdings entered into an Agreement and Plan of Merger (the Inforce Merger Agreement), by and among SMART Global Holdings, Thor Acquisition Sub I, Inc., a California corporation and a wholly-owned indirect subsidiary of the SMART Global Holdings (Merger Sub I), Thor Acquisition Sub II, Inc., a Delaware corporation and a wholly-owned indirect subsidiary of the SMART Global Holdings (Merger Sub II), and Inforce Computing, Inc., a California corporation (Former Inforce). Pursuant to the Inforce Merger Agreement, on July 9, 2019, Merger Sub I was merged with and into Former Inforce, with Former Inforce continuing as the surviving corporation (the First Merger) and, immediately following the effectiveness of the First Merger, the surviving corporation of the First Merger was merged with and into Merger Sub II, with Merger Sub II surviving as a wholly-owned indirect subsidiary of SMART Global Holdings (the Inforce Merger). SMART Global Holdings through one or more subsidiaries, paid the Former Inforce equityholders approximately $14.6 million including amounts paid at closing composed of $3.2 million in cash and 382,788 of ordinary shares of SMART Global Holdings valued at $9.1 million, and amounts retained by the Company as security for the sellers’ indemnification obligations as well as any post-closing adjustments to the purchase price (the Holdback) composed of $0.7 million in cash and 67,550 of ordinary shares of SMART Global Holdings valued at $1.6 million. The Company changed the name of Inforce Computing to SMART Wireless Computing, Inc., or SMART Wireless.

Under the acquisition method of accounting, the assets acquired and liabilities assumed of SMART Wireless were recorded as of the acquisition date at their respective fair values. The reported consolidated financial condition after completion of the acquisition reflects these fair values. SMART Wireless’ results of operations are included in the consolidated financial statements from the date of acquisition.

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A reconciliation of net cash exchanged in accordance with the Inforce Merger Agreement to the total purchase price as of the closing date of the transaction, July 9, 2019, is presented below (in thousands):

 

 

The total purchase consideration has been allocated to the tangible and intangible assets acquired and liabilities assumed. The assets acquired and liabilities assumed at the acquisition date are based upon their respective fair values summarized below (in thousands):

 

 

Asset categories acquired included working capital, fixed assets, and identified intangible assets. The intangible assets are as follows (in thousands):

 

 

The excess of purchase price over the fair value amounts assigned to the assets acquired and liabilities assumed represents the goodwill amount resulting from the acquisition. The Company does not expect any portion of this goodwill to be deductible for tax purposes. The goodwill attributable to the SMART Wireless acquisition has been recorded as a noncurrent asset and is not amortized, but is subject to an annual review for impairment. Factors that contributed to the recognition of goodwill include the broader reach and capabilities of the Company into new technologies, markets and channels that leverage its existing products and services. SMART Wireless is a fast growing developer of high-performance production-ready ARM ISA-based embedded computing platforms for IoT applications enabling the next generation of connected devices. SMART Wireless brings an outstanding customer base, solid products and strong supplier relationships to the Company in the medical imaging, video conferencing, AR/VR computing, IIoT, commercial drones and robotics markets. SMART Wireless will have substantially improved access to capital to drive additional investment in, and further development and growth of its products and services.

Due to the timing of acquisition, the total purchase consideration has been allocated to the tangible and intangible assets acquired and liabilities assumed based on a preliminary valuation analysis. These preliminary values may change in future reporting periods upon finalization of the valuation of net working capital adjustment, which will occur no later than the fourth quarter of fiscal 2020. During the three months ended November 29, 2019 and fiscal 2019, the Company incurred certain costs related to the acquisition, which are included in selling, general and administrative expense in the condensed consolidated statement of operations. Merger-related costs include the following (in thousands):        

 

 

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Premiere Logistics

In February 2019, the Company acquired all of the outstanding shares of Premiere Customs Brokers, Inc. and Premiere Logistics, Inc., both privately-held California corporations (collectively Premiere Logistics). The primary purpose of this acquisition is to provide the Company with cost savings solutions in support of its own freight and logistics requirements. In connection with the acquisition, the Company paid upfront cash consideration of $0.2 million.

The assets acquired and liabilities assumed at the acquisition date are based on their respective fair values summarized below (in thousands):

 

 

Results of operations of the businesses acquired have been included in the Company’s consolidated financial statements subsequent to the date of acquisition. The revenue and net income earned by the businesses acquired following the acquisition are not material to our consolidated results of operations.

No pro forma financial information is presented for any of the acquisitions in fiscal 2019 as the impact is not material, individually or in the aggregate, to the Company’s consolidated statements of operations.

Fiscal Year 2018

Penguin Computing

On June 8, 2018, SMART Global Holdings entered into an Agreement and Plan of Merger (the Penguin Merger Agreement), by and among SMART Global Holdings, Glacier Acquisition Sub, Inc., a Delaware corporation and a wholly-owned indirect subsidiary of the SMART Global Holdings (Merger Sub), Penguin Computing, Inc., a California corporation (Penguin) and Fortis Advisors LLC, a Delaware limited liability company, solely in its capacity as the representative of the holders of the securities of Penguin. Pursuant to the Penguin Merger Agreement, on June 8, 2018, Merger Sub was merged with and into Penguin, with Penguin surviving as a wholly-owned indirect subsidiary of SMART Global Holdings (the Penguin Merger). SMART Global Holdings through one or more subsidiaries, paid the Penguin equityholders approximately $45 million at closing and assumed approximately $32.3 million of Penguin’s outstanding indebtedness. SMART Global Holdings financed the acquisition with net proceeds of $60.0 million from the Incremental Amendment (as defined in Note 7). Pursuant to the Penguin Merger Agreement, the former equityholders of Penguin were also entitled to cash earn-out payments of up to $25.0 million based on Penguin’s achievement of specified gross profit levels through December 31, 2018. No earn-out amounts were achieved.

After closing of the Penguin Merger, SMART Global Holdings deposited $6.0 million of the purchase price into escrow as security for Penguin’s indemnification obligations during the escrow period of one year. SMART Global Holdings also deposited $2.0 million of the purchase price into escrow as security for customary post-closing adjustments to the purchase price. SMART Global Holdings notified the sellers of various disputes with respect to the closing balance sheet and other indemnity claims aggregating $4.9 million. While the escrow claims have not been resolved, on July 23, 2019, the parties agreed to release $3.2 million of these funds to the former equityholders and $1.8 million of the escrow funds to SMART Global Holdings.  The balance of $3.0 million remains in escrow.

Under the acquisition method of accounting, the assets acquired and liabilities assumed of Penguin were recorded as of the acquisition date at their respective fair values. The reported consolidated financial condition after completion of the acquisition reflects these fair values. Penguin’s results of operations are included in the consolidated financial statements from the date of acquisition.

The initial fair value of contingent consideration was estimated at the date of acquisition to be $3.0 million, which was recorded as a current liability. The Company determined the fair value of the obligations to pay contingent consideration using a real options technique which incorporates various estimates, including projected gross profit for the period, a volatility factor applied to gross profit based on year-on-year growth in gross profit of comparable companies, discount rates and the estimated amount of time until final payment is made. This fair value measurement is based on significant inputs not observable in the market, which ASU 820-10-35 refers to as Level 3 inputs. The resulting probability-weighted cash flows were discounted using the US Information Technology B Corporate Bond Yields of 4.06%, which is representative of a market participant assumption.

Subsequent to the acquisition date, the Company adjusted the contingent consideration to its current fair value with such changes recognized in income from operations. Changes in fair values reflect new information about the probability and timing of meeting the conditions of the gross profit target. As of August 30, 2019, the fair value of the contingent consideration was $0.

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A reconciliation of net cash exchanged in accordance with the purchase agreement to the total purchase price as of the closing date of the merger, June 8, 2018, is presented below (in thousands):

 

 

The total purchase consideration has been allocated to the tangible and intangible assets acquired and liabilities assumed. The assets acquired and liabilities assumed at the acquisition date are based upon their respective fair values summarized below (in thousands):

 

 

The provisional amounts presented in the table above pertained to the preliminary purchase price allocation reported in our Form 10-K for the fiscal year ended August 31, 2018. The measurement period adjustment, as recognized in the third quarter, is related to the reduction of inventory originally represented by the sellers as held by vendors for repairs. Upon further analysis, the Company confirmed with the vendors that the stated inventory or an obligation by the vendors to refund the Company did not exist as of June 8, 2018, the acquisition date.

We do not believe that the measurement period adjustments had a material impact on our consolidated statements of operations, balance sheets or cash flows in any periods previously reported. The final determination of the fair values were completed within the measurement period of up to one year from the acquisition date, and adjustments to provisional amounts that were identified during the measurement period were recorded in the reporting period in which the adjustment was determined.

 

Asset categories acquired included working capital, fixed assets, and identified intangible assets. The intangible assets are as follows (in thousands):

 

 

The excess of purchase price over the fair value amounts assigned to the assets acquired and liabilities assumed represents the goodwill amount resulting from the acquisition. The Company does not expect any portion of this goodwill to be deductible for tax purposes. The goodwill attributable to the Penguin Merger has been recorded as a noncurrent asset and is not amortized, but is subject to an annual review for impairment. Factors that contributed to the recognition of goodwill include the broader reach and capabilities of the Company into new technologies, markets and channels that leverage its existing products and services. Penguin brings an outstanding customer base, solid products and strong supplier relationships to the Company in the specialty compute, storage and networking markets. Conversely, Penguin will have substantially improved access to capital to drive additional investment in, and further development and growth of its product and services.

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As part of the Penguin Merger, the Company recorded a net deferred tax liability of $1.6 million. This amount was primarily comprised of $7.9 million related to non-goodwill intangible assets and other fair market value adjustments, offset by net deferred tax assets including acquired net operating losses and research credit carryovers totaling $6.3 million.

 

In the normal course of business, the Company had transactions with its affiliates as follows (in thousands):

 

 

As of November 29, 2019 and August 30, 2019, amounts due from these affiliates were $6.2 million and $8.2 million, respectively.

On July 9, 2019, SMART Wireless became a wholly-owned subsidiary of the Company (see Note 2).  Included in the selling shareholders of this acquisition were the Company’s CEO and two members of the Company’s Board of Directors, who became entitled to receive in the aggregate 397,407 in SGH common shares valued at $9.5 million (consisting of 337,692 shares issued upon closing and 59,715 shares that are subject to the Holdback).  

The Company transacts business in various foreign currencies and has international sales and expenses denominated in foreign currencies, subjecting the Company to foreign currency risk. The Company utilizes foreign exchange forward contracts to mitigate foreign currency exchange rate risk associated with foreign-currency-denominated assets and liabilities, primarily third party payables.  The Company does not use foreign currency contracts for speculative or trading purposes.

Foreign exchange forward contracts outstanding at November 29, 2019 are not designated as hedging instruments for hedge accounting purposes. Accordingly, any gains or losses resulting from changes in the fair value of the non-designated forward contracts are reported in other income (expense) in the condensed consolidated income statements. The gains and losses on these forward contracts generally offset the gains and losses associated with the underlying foreign-currency-denominated balances, which are also reported in other income (expense).  

As of November 29, 2019, the Company’s non-designated forward contacts resulted in a $1.0 million derivative liability. As of August 30, 2019, the Company’s non-designated forward contracts resulted in a $36 thousand derivative asset and a $0.2 million derivative liability. For the three months ended November 29, 2019 and November 30, 2018, the Company recognized realized losses in the amount of $0.8 million and $1.3 million, respectively, and net unrealized losses on the change in the fair value of the non-designated forward contracts in the amount of $0.8 million and $1.0 million, respectively.

 

Inventories

Inventories consisted of the following (in thousands):

 

 

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Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consisted of the following (in thousands):

 

 

*See Note 2.

**See Note 1(i).

***See Note 1(d).

Property and Equipment, Net

Property and equipment consisted of the following (in thousands):

 

 

*Includes Penang facility, which is situated on leased land.

Depreciation and amortization expense for property and equipment during the three months ended November 29, 2019 and November 30, 2018 was approximately $6.1 million and $5.4 million, respectively.

Other Noncurrent Assets

Other noncurrent assets consisted of the following (in thousands):

 

 

*See Note 1(i). 

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Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

 

 

*See Note 2

 

Leases

The Company determines if an arrangement is a lease as well as the classification of the lease at inception for arrangements with an initial term of more than 12 months, and classifies it as either finance or operating.

Operating leases are recorded in operating lease right-of-use assets, net, and operating lease liabilities, current and non-current on our condensed consolidated balance sheets. For operating leases of buildings, we account for non-lease components, such as common area maintenance, as a component of the lease, and include it in the initial measurement of our operating lease assets and corresponding liabilities. Operating lease assets are amortized on a straight-line basis in operating expenses over the lease term.

The company does not have finance leases as of November 29, 2019.

Our lease liabilities are recognized based on the present value of the remaining fixed lease payments, over the lease term, using a discount rate of similarly secured borrowings available to us. For the purpose of lease liability measurement, we consider only payments that are fixed and determinable at the time of commencement. Any variable payments that depend on an index or rate are expensed as incurred. Our lease terms may include options to extend when it is reasonably certain that we will exercise that option. Our lease assets also include any lease payments made and exclude any lease incentives received prior to commencement. Our lease assets are tested for impairment in the same manner as long-lived assets used in operations. We generally recognize sublease income on a straight-line basis over the sublease term.

The weighted-average remaining lease term for our operating leases was 8 years at November 29, 2019 and the weighted-average discount rate was 8.2%.

The components of lease costs are as follows (in thousands):

 

 

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Future minimum undiscounted payments under our non-cancelable operating leases were as follows as of November 29, 2019 (in thousands):

 

 

Right-of-use assets obtained in exchange for new operating lease liabilities for the three months ended November 29, 2019 amounted to $4.7 million.

 

 

Provision for income taxes for the three month periods presented consisted of the following (in thousands):

 

 

Income tax expense includes a provision for federal, state and foreign taxes based on the annual estimated effective tax rate applicable to the Company and its subsidiaries, adjusted for certain discrete items which are fully recognized in the period they occur.

Provision for income taxes for the three months ended November 29, 2019 decreased by $7.3 million as compared to the same period in the prior year, primarily due to lower income in non-U.S. jurisdictions subject to tax.  

As of November 29, 2019, the Company has a full valuation allowance for its net deferred tax assets associated with its U.S. operations.  The amount of the deferred tax asset considered realizable could be adjusted if significant positive evidence increases.

Determining the consolidated provision for income tax expense, income tax liabilities, and deferred tax assets and liabilities involves judgment. The Company calculates and provides for income taxes in each of the tax jurisdictions in which it operates, which involves estimating current tax exposures, as well as making judgments regarding the recoverability of deferred tax assets in each jurisdiction.  The estimates used could differ from actual results, which may have a significant impact on operating results in future periods.

Amended Credit Agreement

On August 9, 2017, SMART Worldwide, SMART Modular Technologies (Global), Inc. (Global), and SMART Modular Technologies, Inc. (SMART Modular) entered into a Second Amended and Restated Credit Agreement (together with all related loan documents, as amended from time to time including as amended by the Incremental Amendment as defined below, the Amended Credit Agreement) with certain lenders which amended and restated that certain Amended and Restated Credit Agreement dated as of November 5, 2016 (the ARCA), which had amended and restated that certain Credit Agreement dated as of August 26, 2011 (the Original Credit Agreement). The Company’s subsidiaries named as borrowers in the Amended Credit Agreement and certain other subsidiaries that entered into a guarantee with respect to the Amended Credit Agreement including Penguin, SMART EC and SMART Wireless, are collectively referred to as the Loan Parties and together with SMART Modular Technologies Sdn. Bhd. (SMART Malaysia), the Credit Group. The Amended Credit Agreement provides for a $165 million of initial term loans (the Initial Term Loan) with a maturity date of August 9, 2022, and $50 million of revolving loans with a maturity date of February 9, 2021 (the Initial Revolver Maturity Date) which revolving loan maturity date automatically extends to February 9, 2022 if the total leverage ratio of the Credit Group is less than 3.0:1.0 on the Initial Revolver Maturity Date. SMART Global Holding is not a party to the Amended Credit Agreement.

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On June 8, 2018, SMART Worldwide, Global and SMART Modular entered into an Incremental Facility Agreement (the Incremental Amendment) which provided for incremental term loans under the Amended Credit Agreement in the aggregate amount of $60 million (the Incremental Term Loans) which Incremental Term Loans are on substantially identical terms as the Initial Term Loans. Pursuant to the Incremental Amendment, the borrowers agreed to pay the structuring advisor a $0.6 million fee pursuant to a separate agreement.

On October 2, 2018, SMART Worldwide, SMART Worldwide, Global and SMART Modular entered into the Second Amendment to the Amended Credit Agreement (the Second Amendment) which did not become effective until October 25, 2018. As a result of the Second Amendment, the borrowers were granted a holiday from the obligation to make quarterly repayments of principal under the Initial Term Loans and the Incremental Term Loans at any time with respect to fiscal 2019. In addition, the borrowers were granted a holiday from the obligation to repay any loans as a result of excess cash flow that would otherwise be due with respect to any period of fiscal 2019.

The Amended Credit Agreement is jointly and severally guaranteed on a senior basis by certain subsidiaries of Global (excluding, among other subsidiaries, SMART Malaysia). In addition, the Amended Credit Agreement is secured by a pledge of the capital stock of, or equity interests in, most of the subsidiaries of SMART Worldwide (including, without limitation, SMART Malaysia, Penguin, SMART EC and SMART Wireless) and by substantially all of the assets of the subsidiaries of SMART Worldwide, excluding the assets of SMART Malaysia and certain other subsidiaries.

Covenants. The Amended Credit Agreement contains various representations and warranties and affirmative and negative covenants that are usual and customary for loans of this nature including, among other things, limitations on the Credit Group’s ability to engage in certain transactions, incur debt, pay dividends, and make investments. The Amended Credit Agreement also requires that the Credit Group maintain a Secured Leverage Ratio not in excess of 3.5:1.0 as of the end of each fiscal quarter (commencing with the fiscal quarter ending November 24, 2017) and puts restrictions on the Credit Group’s ability to retain cash proceeds from the sale of certain assets with net proceeds in excess of $2 million, subject to customary six-month reinvestment rights. The Incremental Amendment required the Credit Group to repay the Penguin Credit Facility, as defined below, and to pledge as collateral, all of the capital stock of and substantially all of the assets of Penguin within 60 days after the closing of the Penguin acquisition.

Interest and Interest Rates. Loans under the Amended Credit Agreement accrue interest at a rate per annum equal to an applicable margin plus, at the borrowers’ option, either a LIBOR rate, or a base rate. The applicable margin for term loans with respect to LIBOR borrowings is 6.25% and with respect to base rate borrowings is 5.25%. The interest rate on the Initial Term Loans and Incremental Term Loans was 8.16% and 8.39% as of November 29, 2019, respectively.

The applicable margin for revolving loans adjusts every quarter based on the Secured Leverage Ratio for the most recent fiscal quarter with the applicable margin for revolving loans with respect to LIBOR borrowings ranging from 3.75% to 4.00% and the applicable margin for revolving loans with respect to base rate borrowings ranging from 2.75% to 3.00%.

Interest on base rate loans is payable on the last day of each calendar quarter. Interest on LIBOR-based loans is payable every one, two, three, six or twelve months after the date of each borrowing, depending on the particular interest rate period selected with respect to such borrowing.

Principal Payments. The Amended Credit Agreement requires quarterly repayments of principal under the Initial Term Loans equal to 2.5% of $165 million, or $4.1 million per fiscal quarter and, commencing on November 30, 2018, quarterly repayments of principal under the Incremental Term Loans equal to 2.5% of $60 million, or $1.5 million per fiscal quarter.  As a result of the Second Amendment, the borrowers were granted a holiday in fiscal 2019 from the obligation to make repayments of principal under the Initial Term Loans and the Incremental Term Loans. During the three months ended November 29, 2019 and November 30, 2018, the borrowers made scheduled principal payments of $5.6 and $0 million, respectively.

Prepayments. The borrowers have the right at any time to make optional prepayments of the principal amounts outstanding under the Amended Credit Agreement provided that prepayments of principal which are voluntary or are made in connection with certain transactions will be subject to prepayment premiums of 3%, 2%, and 1% during the first, second and third years, respectively, after the effective date of the Amended Credit Agreement.

The Amended Credit Agreement also requires certain mandatory prepayments of principal whereby the borrowers must prepay outstanding loans, subject to certain exceptions, which includes, among other things:

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As a result of the Second Amendment, the borrowers were granted a holiday from the obligation to repay any loans as a result of excess cash flow that would otherwise be due with respect to any period of fiscal 2019. No mandatory prepayments were required for three months ended November 29, 2019 or for fiscal 2019.

On June 2, 2017, SMART Global Holdings contributed $61.0 million from the proceeds of the IPO closed in May 2017. Global in turn used the proceeds to pay down the original term loans under the Original Credit Agreement, as required under the ARCA, which resulted in a $6.7 million loss on early repayment of long-term debt. As of August 9, 2017, prior to the one year anniversary of the ARCA, the Credit Group entered into the Amended Credit Agreement with new term loans in the aggregate principal amount of $165 million with different lenders. The proceeds from the Amended Credit Agreement were used to fully repay and refinance the term loans under the ARCA in the principal amount of $151.0 million, which resulted in a write off of $15.2 million of original issue discount and debt issuance costs as an extinguishment loss.

Term loans under the Amended Credit Agreement were issued at a discount of 2.0% of the then outstanding principal amount of $165 million, for a discount of $3.3 million. The Company incurred $8.7 million in debt issuance costs upon entering into the Amended Credit Agreement, of which $5.3 million was attributable to the term loans and recorded as a direct reduction to the face amount of the term loans, and $3.4 million was allocated to the revolving line of credit and recorded as a separate asset on the balance sheet. Debt issuance costs and debt discount related to term loans are being amortized to interest expense based on the effective interest rate method over the life of the term loans. Those fees allocated to the revolving line of credit are being amortized to interest expense ratably over the life of the revolving line of credit.

As of November 29, 2019 and August 30, 2019, the outstanding principal balance of all term loans under the Amended Credit Agreement was $202.9 million and $208.5 million, respectively, and there were no outstanding revolving loans. The fair value of the term loans as of November 29, 2019 and August 30, 2019 was estimated to be approximately $204.9 million and $210.6 million, respectively. Since the Company used broker quotes from inactive markets and there were no unobservable inputs, this was treated as a Level 2 financial instrument.

BNDES Credit Agreements

In December 2013, SMART Brazil, entered into a credit facility with the Brazilian Development Bank, or BNDES (such loan the BNDES 2013 Credit Agreement). Under the BNDES 2013 Credit Agreement, a total of R$50.6 million (or $12.6 million) was made available to SMART Brazil for investments in infrastructure, research and development conducted in Brazil and acquisitions of equipment not otherwise available in the Brazilian domestic market. SMART Brazil’s obligations under the BNDES 2013 Credit Agreement were guaranteed by Banco Itaú BBA S.A., or Itaú Bank, which guarantee was in turn secured by a guarantee from SMART Brazil and SMART do Brazil in favor of Itaú Bank and a commitment by SMART Brazil to maintain minimum cash balances with Itaú Bank equal to 11.85% of the maximum aggregate balance of principal, interest and fees outstanding under the BNDES 2013 Credit Agreement.

Approximately half of the available debt under the BNDES 2013 Credit Agreement accrues interest at a fixed rate while the other half accrues interest at a floating rate. The facility under the BNDES 2013 Credit Agreement is a term loan fully amortizing in 48 equal monthly installments beginning on August 15, 2015 with the final principal payment being due on July 15, 2019.

As of November 29, 2019 and August 30, 2019, SMART Brazil had no outstanding debt under the BNDES 2013 Credit Agreement.

In December 2014, SMART Brazil, entered into a second credit facility with BNDES, referred to as the BNDES 2014 Credit Agreement. The BNDES 2013 Credit Agreement and the BNDES 2014 Credit Agreement are collectively referred to as the BNDES Credit Agreements. Under the BNDES 2014 Credit Agreement, a total of R$52.8 million (or $13.2 million) was made available to SMART Brazil for research and development conducted in Brazil related to integrated circuit (IC) packaging and for acquisitions of equipment not otherwise available in the Brazilian domestic market.

Prior to July 2018, SMART Brazil’s obligations under the BNDES 2014 Credit Agreement was also guaranteed by Itaú Bank, which guarantee was in turn secured by a guarantee from SMART Brazil and SMART do Brazil in favor of Itaú Bank and a commitment by SMART Brazil to maintain minimum cash balances with Itaú Bank equal to 30.31% of the maximum aggregate balance of principal, interest and fees outstanding under the BNDES 2014 Credit Agreement, or approximately R$16.0 million (or $4.3 million) of required cash balances.

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In July 2018, SMART Brazil entered into guarantee arrangements with Banco Votorantim S.A. which bank in turn replaced the guarantees of the BNDES Credit Agreements previously issued by Itaú Bank.  As a result, the guarantees with Itaú Bank were cancelled and Itaú Bank returned R$22.0 million (or $5.9 million) of committed balances to SMART Brazil in the first quarter of fiscal 2019. As such, the Company no longer has any restricted cash on its condensed consolidated balance sheets as of November 29, 2019.

The available debt under the BNDES 2014 Credit Agreement accrues interest at a fixed rate of 4% per annum. The BNDES 2014 Credit Agreement is a term loan fully amortizing in 48 equal monthly installments beginning on August 15, 2016 with the final principal payment being due on July 15, 2020.

As of November 29, 2019 and August 30, 2019, SMART Brazil’s outstanding debt under the BNDES 2014 Credit Agreement was R$9.9 million (or $2.5 million) and R$13.2 million (or $3.5 million), respectively.

While the BNDES Credit Agreements do not include any financial covenants, they contain affirmative and negative covenants customary for loans of this nature, including, among other things, an obligation to comply with all laws and regulations; a right for BNDES to terminate the loan in the event of a change of effective control; and a prohibition against the disposition or encumbrance, without BNDES consent, of intellectual property developed with the funds from the loans. The BNDES 2013 Credit Agreement includes an obligation to draw down the entire loan within specified periods of time or pay unused commitment fees of 0.1%. The BNDES 2014 Credit Agreement required a loan fee of 0.3% of the total face amount of the loan facility.

The fair value of amounts outstanding under the BNDES Credit Agreements as of November 29, 2019 and August 30, 2019 were estimated to be approximately $2.4 million and $3.3 million, respectively. Since the Company used broker quotes from inactive markets and there were no unobservable inputs, this was treated as a Level 2 financial instrument.

The Amended Credit Agreement and the BNDES 2014 Agreement are classified as follows in the accompanying consolidating balance sheets (in thousands):

 

 

The future minimum principal payments under the Amended Credit Agreement and the BNDES 2014 Agreement as of November 29, 2019 are (in thousands):

 

 

Fair Value of Financial Instruments

The fair value of the Company’s cash, cash equivalents, accounts receivable and accounts payable approximates the carrying amount due to the relatively short maturity of these items. Cash and cash equivalents consist of funds held in general checking and savings accounts, money market accounts, and securities with maturities of less than 90 days at the time of purchase. The Company does not have investments in variable rate demand notes or auction rate securities.

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The FASB guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets to identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

Assets and liabilities measured at fair value on a recurring basis include the following (in millions):

 

 

 

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Equity Awards

On August 26, 2011, the board of directors adopted the Saleen Holdings, Inc. 2011 Stock Incentive Plan which was amended and restated as of May 18, 2017 to be known as the SMART Global Holdings, Inc. Amended and Restated 2017 Share Incentive Plan. On January 29, 2019, the shareholders approved an amendment to the SMART Global Holdings, Inc. Amended and Restated 2017 Share Incentive Plan (as amended, the SGH Plan) which amendment increased the reserve under the SGH Plan by 1,500,000 shares effective as of February 1, 2019. The SGH Plan provides for grants of equity awards to employees, directors and consultants of SMART Global Holdings and its subsidiaries. Options granted under the SGH Plan provide the option to purchase SMART Global Holdings’ ordinary shares at the fair value of such shares on the grant date. The options and RSUs generally vest over a four-year period beginning on the grant date and generally have a ten-year term. Options granted after August 26, 2011 and before September 23, 2014 have an eight year term. As of November 29, 2019, there were 5,238,787 ordinary shares reserved for issuance under the SGH Plan, of which 2,106,081 ordinary shares were available for grant. As of August 30, 2019, there were 4,803,315 ordinary shares reserved for issuance under the SGH Plan, of which 1,427,339 ordinary shares were available for grant.

Summary of Assumptions and Activity

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table.

The expected volatility is based on the historical volatilities of the common stock of comparable publicly traded companies. The expected term of options granted represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and the historical exercise patterns. The risk-free interest rate for the expected term of the option is based on the average U.S. Treasury yield curve at the end of the quarter in which the option was granted.

The following assumptions were used to value the Company’s stock options:

 

 

SGH Plan—Options

A summary of option activity for the SGH Plan is presented below (dollars and shares in thousands, except per share data):

 

 

 

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In March 2018, the Company granted two performance-based stock options that contained a stock market index as a benchmark for performance (Market-Based Options). The share-based compensation expense for these options is recognized over the requisite service period by tranche. The exercisability of Market-Based Options will depend upon the 30-trading day rolling average closing price of Company’s ordinary shares. If the target price is not achieved by the end of 4^th or 7^th anniversary of the respective grant date, the options will expire. One of the performance-based stock options was cancelled in November 2019, resulting in an additional $2.0 million share-based compensation expense recorded in the three months ended November 29, 2019. The fair value of Market-Based Options is determined by using a Monte Carlo valuation model, using the following assumptions:

 

 

The Black-Scholes weighted average fair value of options granted under the SGH Plan during the three months ended November 29, 2019 and November 30, 2018 was $11.85 and $14.41 per share, respectively. The total intrinsic value of employee stock options exercised in the three months ended November 29, 2019 and November 30, 2018 was $1.3 million and $4.1 million, respectively. As of November 29, 2019, there was approximately $14.4 million of unrecognized compensation costs related to stock options under the SGH Plan, which will be recognized over a weighted average period of 2.33 years.

SGH Plan—Restricted Stock Awards (RSAs), Restricted Stock Units (RSUs) and Performance Stock Units (PSUs)

A summary of the changes in RSAs and RSUs outstanding is presented below (dollars and shares in thousands, except per share data):

 

 

In May 2019, the Company granted a performance-based restricted share unit award (PSU) which has both service and performance conditions. As of November 29, 2019, the Company deemed it probable that the service condition will be met, however, since the attainment of the performance condition for this award changed to not probable, there was $0.8 million of share-based compensation expense reversed for this award in the three months ended November 29, 2019.  

The share-based compensation expense related to RSAs, RSUs and PSUs during the three months ended November 29, 2019 and November 30, 2018 was approximately $1.9 million and $1.6 million, respectively. The total fair value of shares vested during the three months ended November 29, 2019 and November 30, 2018 was approximately $2.1 million and $1.7 million, respectively. As of November 29, 2019, there was approximately $22.4 million of unrecognized compensation costs related to awards under the SGH Plan, which will be recognized over a weighted average period of 2.40 years.

Employee Share Purchase Plan

In January 2018, the Company’s shareholders approved the SGH 2018 Employee Share Purchase Plan (the Purchase Plan) under which an aggregate of 650,000 of ordinary shares have been approved for issuance to eligible employees. The Purchase Plan generally permits employees to purchase ordinary shares at 85% of the lower of the fair market value of the ordinary shares at the beginning or at the end of each purchase period, which is generally six months. Rights to purchase ordinary shares are granted during the first and third quarter of each fiscal year.  The Purchase Plan terminates in January 2028. As of November 29, 2019, 176,484 ordinary shares have been purchased under the Purchase Plan and 773,516 ordinary shares are reserved for future purchases by eligible employees. As of August 30, 2019, 109,910 ordinary shares have been purchased under the Purchase Plan and 540,090 ordinary shares are reserved for future purchases by eligible employees.

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Equity Rights and Restrictions

The holders of ordinary shares of SMART Global Holdings are entitled to such dividends and other distributions as may be declared by the board of directors of SMART Global Holdings from time-to-time, out of the funds of SMART Global Holdings lawfully available therefor.

Substantially all SMART Global Holdings shares owned by employees, by certain former lenders of the Company, and all shares underlying the SMART Global Holdings options, PSUs and RSUs are subject to either the Employee Investors Shareholders Agreement dated August 26, 2011 (the Employee Investors Shareholders Agreement), the Amended and Restated Investors Shareholders Agreement dated as of November 5, 2016 (as amended by Amendment No. 5, Amendment No. 4, Amendment No. 3, Amendment No. 2 and subsequent amendments, the Amended and Restated Investors Shareholders Agreement) and the Amended and Restated Sponsors Shareholders Agreement dated May 30 2017 (as amended, the Sponsor Shareholder Agreement; the Employee Investors Shareholders Agreement, the Amended and Restated Investors Shareholders Agreement and the Sponsor Shareholder Agreement are collectively referred to as the Shareholders Agreements). Under the terms of the Shareholders Agreements, such shares are subject to certain restrictions on sale and could become subject to lock-up restrictions in the event of any future registered public offerings by the Company.

The Company offers a 401(k) Plan to U.S. employees, which provides for tax-deferred salary deductions for eligible U.S. employees. Employees may contribute up to 60% of their annual eligible compensation to this plan, limited by an annual maximum amount determined by the U.S. Internal Revenue Service. The Company may also make discretionary matching contributions, which vest immediately, as periodically determined by management. The matching contributions made by the Company during the three months ended November 29, 2019 and November 30, 2018 were approximately $0.4 million and $0.4 million, respectively.

Minimum rent payments under operating leases are recognized on a straight-line basis over the term of the lease including any periods of free rent. Rent expense for operating leases during the three months ended November 29, 2019 and November 30, 2018 was $1.8 million and $1.2 million, respectively.

Future minimum lease payments under all leases as of August 30, 2019 are as follows (in thousands):

 

 

Refer to Note 5 for related fiscal 2020 information on leases.

 

Product warranty reserves are established in the same period that revenue from the sale of the related products is recognized, or in the period that a specific issue arises as to the functionality of a Company’s product. The amounts of the reserves are based on established terms and the Company’s best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date.

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The following table reconciles the changes in the Company’s accrued warranty (in thousands):

 

 

Product warranty reserves are recorded in accrued liabilities in the accompanying condensed consolidated balance sheets.

In addition to potential liability for warranties related to defective products, the Company currently has in effect a number of agreements in which it has agreed to defend, indemnify and hold harmless its customers and suppliers from damages and costs, which may arise from product defects as well as from any alleged infringement by its products on third-party patents, trademarks or other proprietary rights. The Company believes its internal development processes and other policies and practices limit its exposure related to such indemnities. Maximum potential future payments cannot be estimated because many of these agreements do not have a maximum stated liability. However, to date, the Company has not had to reimburse any of its customers or suppliers for any losses related to these indemnities. The Company has not recorded any liability in its financial statements for such indemnities.

From time to time, the Company is involved in legal matters that arise in the normal course of business. Litigation in general and intellectual property, employment and shareholder litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. The Company believes that it has defenses to the cases pending, including those set forth below. Except as noted below, the Company is not currently able to estimate, with reasonable certainty, the possible loss, or range of loss, if any, from such legal matters, and accordingly, no provision for any potential loss, which may result from the resolution of these matters, has been recorded in the accompanying condensed consolidated financial statements.

Indemnification Claims by SanDisk

In August 2013, the Company completed the sale (the Sale) of substantially all of the business unit which was focused on solid state drives, to SanDisk Corporation (now a part of Western Digital). In connection with the Sale the sale agreement (Sale Agreement) contained certain indemnification obligations, including, among others, for losses arising from breaches of representations and warranties relating to the Sale. These indemnification obligations are subject to a number of limitations, including certain deductibles and caps and limited time periods for making indemnification claims. On August 21, 2014, SanDisk made a claim against the Company under the indemnification provisions of the Sale Agreement in connection with a lawsuit filed by Netlist, Inc. (Netlist) against SanDisk alleging that certain products sold in the Sale infringe various Netlist patents, which SanDisk in turn alleges would, if true, constitute a breach of representations and warranties under the Sale Agreement. Under the Sale Agreement, the Company’s indemnification obligation in respect of intellectual property matters, such as those claimed by SanDisk, is subject to a deductible of approximately $1.8 million and a cap of $60.9 million. As required in the Sale Agreement, the SanDisk claim purported to include a preliminary good faith estimate of SanDisk’s alleged indemnifiable losses, which estimate was greater than the Sale Agreement cap for intellectual property matters. The Company believes that the allegations giving rise to the indemnification claim are without merit and the Company is disputing SanDisk’s claim for indemnification. In addition, there may be other grounds for the Company to dispute the indemnification claim and/or the amounts of any indemnifiable losses of SanDisk.

Import Duty Tax assessment in Brazil

On February 23, 2012, SMART Brazil was served with a notice of a tax assessment for approximately R$117 million (or $29.2 million) (the First Assessment). The First Assessment was from the federal tax authorities of Brazil and related to four taxes in connection with importation processes. The tax authorities claimed that SMART Brazil categorized its imports of unmounted integrated circuits in the format of wafers under an incorrect product classification code, which carries an import duty of 0%. The authorities alleged that a different classification code should have been used that would require an 8% import duty and the authorities were seeking to recover these duties, as well as other related taxes, for the five calendar years of 2007 through and including 2011. Subsequent to the initial assessment, SMART Brazil received a second notice of an additional administrative penalty of approximately R$6.0 million (or $1.5 million) directly related to the same issue and which has been imposed exclusively for the alleged usage of an inappropriate import tax code (the Second Assessment).

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In March 2012, SMART Brazil filed defenses to the First Assessment and the Second Assessment. On May 2, 2013, the first level administrative tax court issued a ruling in favor of the tax assessor and against SMART Brazil on the First Assessment. On May 31, 2013, SMART Brazil filed an appeal to the second level tax court known as CARF. The appeal was heard on November 26, 2013 and SMART Brazil received a unanimous favorable ruling rejecting the position of the tax authorities. Subsequently, the tax authorities filed a request for clarification and on September 17, 2014, SMART Brazil received a unanimous ruling rejecting the request from the tax authorities for clarification. On November 7, 2014, the tax authorities notified CARF that they would not be appealing the CARF decision, and the First Assessment has been extinguished. On February 6, 2018, the first level administrative court unanimously ruled in favor of SMART Brazil with respect to the Second Assessment. Due to the size of the Second Assessment, Brazil law required that the tax authorities appeal the decision to CARF. The appeal on the Second Assessment was heard on December 11, 2018 and SMART Brazil received a unanimous favorable ruling rejecting the position of the tax authorities. The tax authorities did not file any request for clarification or appeal and, as a result, the Second Assessment was extinguished in May 2019.

On December 12, 2013, SMART Brazil received another notice of assessment in the amount of R$3.6 million (or $1.0 million) with respect to the same import-related tax issues and penalties discussed above for 2012 and 2013 (the Third Assessment). The Third Assessment does not seek import duties and related taxes on Dynamic Random Access Memory (DRAM) products and only seeks import duties and related taxes on Flash unmounted components with respect to the months of January 2012 to June 2012. This is because SMART Brazil’s imports of DRAM unmounted components were subject to 0%, and, after June 2012, SMART Brazil’s imports of Flash unmounted components also became subject to 0% import duties and related taxes, both as a result of PADIS. Even with this 0%, if SMART Brazil is found to have used the incorrect product classification code, SMART Brazil will be subject to an administrative penalty equal to 1% of the value of the imports. SMART Brazil has filed defenses to the Third Assessment. The Company believes that SMART Brazil used the correct product code on its imports and that the Third Assessment is incorrect. SMART Brazil intends to vigorously fight this matter. Although SMART Brazil did not receive the Third Assessment until December 12, 2013, the Third Assessment was issued before the CARF decisions in favor of SMART Brazil on the First Assessment and the Second Assessment were published.

The amounts claimed by the tax authorities on the Third Assessment are subject to increases for interest and other charges, which resulted in a combined assessment balance of approximately R$5.6 million (or $1.4 million) as of November 29, 2019.

As a result of the CARF decisions in favor of SMART Brazil on the First Assessment and the Second Assessment, the Company believes that the probability of any material charges as a result of the Third Assessment is remote and the Company does not expect the resolution of these disputed assessments to have a material impact on its consolidated financial position, results of operations or cash flows. While the Company believes that the Third Assessment is incorrect, there can be no assurance that SMART Brazil will prevail in the disputes.

The Company’s chief operating decision-maker (CODM), the President and CEO, evaluates operating results to make decisions about allocating resources and assessing performance of the company. Prior to the start of fiscal 2020, the Company operated in one segment.  During the first quarter of fiscal year 2020, management further reevaluated and refined its segment reporting to align with the Company's broader strategy and how it manages business operations, driven in part by the Company’s recent business acquisitions.  The Company now operates in three segments consisting of Specialty Memory Products, Brazil Products and SCSS. These segments are determined based on source of revenue and geography. The Company's CODM evaluates the operating results and performance of the segments based on gross profit and gross margin. The accompanying prior year disclosures have been revised to reflect this change. The accounting policies and basis of presentation of the reportable segments are the same as those described in Note 1 – “Basis of Presentation and Principals of Consolidation.”

The following table shows operating results net of inter-segment revenues, which, for the respective three months ended, are not material to the financial statements (dollars in thousands):

 

 

 

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A summary of the Company’s net sales by geographic area, based on the ship-to location of the customer, property and equipment by geographic area is as follows (in thousands):

 

 

 

A majority of the Company’s net sales are attributable to customers operating in the information technology industry. Net sales to significant end user customers, including sales to their manufacturing subcontractors, defined as net sales in excess of 10% of total net sales, are as follows (dollars in thousands):

 

 

(2)Specialty Memory Products customer

 

As of November 29, 2019, three direct customers that represented less than 10% of net sales, Customers D, E, and F, accounted for approximately 15%, 14% and 14% of accounts receivable, respectively. As of August 30, 2019, three direct customers that represented less than 10% of net sales, Customers D, E, and F, accounted for approximately 15%, 15% and 12% of accounts receivable, respectively.

Basic earnings per share is calculated by dividing net income (loss) by the weighted average of ordinary shares outstanding during the period. Diluted earnings per share is calculated by dividing the net income (loss) by the weighted average of ordinary shares and dilutive potential ordinary shares outstanding during the period. Dilutive potential ordinary shares consist of dilutive shares issuable upon the exercise of outstanding stock options and vesting of RSUs computed using the treasury stock method. The dilutive weighted shares are excluded from the computation of diluted net loss per share when a net loss is recorded for the period as their effect would be anti-dilutive.

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The following table sets forth for all periods presented the computation of basic and diluted earnings per share, including the reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per share (dollars and shares in thousands, except per share data):

 

 

 

The following table provides the detail of other income (expense), net as follows (in thousands):

 

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the notes to those statements included elsewhere in this Quarterly Report on Form 10-Q, and with the condensed consolidated financial statements and management’s discussion and analysis of our financial condition and results of operations in our Annual Report on Form 10-K for our fiscal year ended August 30, 2019 (our “Annual Report”). This discussion contains forward looking statements that involve risks and uncertainties. Our actual results could differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed under the caption “Risk Factors” in our Annual Report and elsewhere in this report. See also “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this report.

Overview

The SMART lines of business are leading designers and manufacturers of electronic products focused on memory and computing technology areas. The company specializes in application specific product development and support for customers in enterprise, government and OEM sales channels. Customers rely on SMART as a strategic supplier with top tier customer service, product quality, and technical support with engineering, sales, manufacturing, supply chain and logistics capabilities worldwide. The company targets customers in markets such as communications, storage, networking, mobile, industrial automation, industrial internet of things, government, military, edge computing and high performance computing.  SMART operates in three segments: Specialty Memory products, Brazil products and Specialty Compute and Storage Solutions, or SCSS.

 

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Results of Operations

The following is a summary of our results of operations for the three months ended November 29, 2019 and November 30, 2018:

 

 

Three Months Ended November 29, 2019 as Compared to the Three Months Ended November 30, 2018

Net Sales

Net sales decreased by $121.9 million, or 30.9%, during the three months ended November 29, 2019 compared to the same period in the prior year. Net sales were negatively impacted by a decrease in Brazil product sales of $105.3 million, or a decline of 52.8%. The Brazil product sales decrease was mainly due to lower average selling prices for both mobile memory and DRAM products having declines of 71% and 67%, respectively, as raw material costs decreased by 52%. In addition, our sales of Specialty products had a decrease of $36.4 million, or a decline of 26.0%, mainly due to lower revenue from Specialty DRAM products resulting from 34% lower average selling prices as raw material costs declined by 25%, and product mix.  The decreases in Brazil and Specialty were partially offset by additional revenue from SCSS of $19.8 million, or an increase of 36.3%, mainly driven by our two recent acquisitions in July 2019 which contributed $27.5 million of revenue for the quarter.

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Cost of Sales

Cost of sales decreased by $91.1 million, or 29.5%, during the three months ended November 29, 2019 compared to the same period in the prior year. Due to lower sales, cost of sales had lower raw material costs decreased $72.7 million (or 52%) and $19.3 million (or 25%) for Brazil Products and Specialty Memory Products. These decreases were offset in part, by a net increase in SCSS raw material costs of $2.0 million (or 5%) mainly due to the July 2019 acquisitions, partially offset by lower Penguin. Included in the cost of sales decrease was a favorable foreign exchange impact of $0.4 million due to locally sourced cost of sales in Brazil.

Gross Profit

Gross margin decreased to 20.0% during the three months ended November 29, 2019 compared to 21.6% for the same period in the prior year, primarily due to fixed manufacturing costs on lower revenue for Brazil, as well as higher cost of sales for our SCSS businesses.

Research and Development Expense

Research and development (“R&D”) expense increased by $3.1 million, or 26.0%, during the three months ended November 29, 2019 compared to the same period in the prior year. The increase was primarily due to $3.5 million of higher costs from our new SCSS businesses. Included in the R&D expense increase was a favorable foreign exchange impact of $0.1 million.  

Selling, General and Administrative Expense

Selling, general and administrative (“SG&A”) expense increased by $8.1 million, or 31.8%, during the three months ended November 29, 2019 compared to the same period in the prior year. The increase was primarily due to $5.7 million higher costs from our new SCSS businesses, as well as higher costs associated with our acquisitions, integration expenses and facilities expense. Included in the SG&A expense increase was a favorable foreign exchange impact of $0.1 million.  

Other Income (Expense)

Interest expense, net decreased $1.4 million, or 23.5%, during the three months ended November 29, 2019 compared to the same period in the prior year, primarily due to higher interest income due to increased cash and lower revolver fees resulting from reduced borrowings. Other expense, net decreased by $2.5 million primarily due to lower foreign currency losses.

Provision for Income Taxes

Income tax expense includes a provision for federal, state and foreign taxes based on the annual estimated effective tax rate applicable to SMART, adjusted for certain discrete items which are fully recognized in the period they occur.

Provision for income taxes for the three ended November 30, 2018 decreased by $7.3 million, as compared to the same period in the prior year primarily due to lower profits in certain non-U.S. jurisdictions subject to tax.  

As of November 29, 2019, SMART has a full valuation allowance for our net deferred tax assets associated with our U.S. operations. The amount of the deferred tax asset considered realizable could be adjusted if significant positive evidence increases.

Determining the consolidated provision for income tax expense, income tax liabilities and deferred tax assets and liabilities involves judgment. SMART calculates and provides for income taxes in each of the tax jurisdictions in which it operates, which involves estimating current tax exposures as well as making judgments regarding the recoverability of deferred tax assets in each jurisdiction. The estimates used could differ from actual results, which may have a significant impact on operating results in future periods.

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Liquidity and Capital Resources  

 

 

 

At November 29, 2019, we had cash and cash equivalents of $111.4 million, of which approximately $83.1 million was held outside of the United States.

In July 2019, we acquired SMART EC and SMART Wireless for purchase prices of approximately $77 million and $14 million, respectively. We financed these acquisitions using cash from operations, as well as approximately $11 million in SGH ordinary shares issued in connection with the SMART Wireless acquisition.

In June 2018, we acquired Penguin for a purchase price of approximately $44 million and assumed approximately $32.3 million of Penguin’s outstanding indebtedness. We financed the acquisition with net proceeds from the $60 million Incremental Amendment. See Note 7 for additional information on our long-term debt agreements.

We expect that our existing cash and cash equivalents, line of credit and cash generated by operating activities will be sufficient to fund our operations for at least the next twelve months. Our principal uses of cash and capital resources are acquisitions, debt service requirements as described below, capital expenditures, R&D expenditures and working capital requirements. We expect that future capital expenditures will focus on expanding capacity of our operations, expanding our R&D activities, manufacturing equipment upgrades and/or acquisitions and IT infrastructure and software upgrades. Cash and cash equivalents consist of funds held in demand deposit accounts and money market funds. We do not enter into investments for trading or speculative purposes.

During the three months ended November 29, 2019, cash provided by operating activities was $25.3 million. The primary factors affecting our cash flows during this period were $0.2 million of net income, $16.4 million of non-cash related expenses and a $8.6 million change in our net operating assets and liabilities. The $8.6 million change in net operating assets and liabilities consisted of increases of $13.7 million in accounts receivable and $42.2 million in inventory, and a decrease of $1.1 million of operating lease liabilities, offset by a decrease of $5.1 million in prepaid expenses and other assets and increases of $60.4 million of accounts payable and $0.1 million in accrued expense and other liabilities. The increase in accounts receivable was primarily due to timing of sales, while the increases in inventory and accounts payable were primarily due to the transition of inventory from contract manufacturers to the company due to our recent acquisitions, as well as higher purchases for certain programs.

During the three months ended November 30, 2018, cash provided by operating activities was $35.4 million. The primary factors affecting our cash flows during this period were $31.0 million of net income and $11.5 million of non-cash related expenses, partially offset by a $7.1 million change in our net operating assets and liabilities. The $7.1 million change in net operating assets and liabilities consisted of increases of $89.4 million in accounts receivable and $3.2 million in prepaid expenses and other assets, offset by a decrease of $30.6 million in inventory, and increases of $48.5 million in accounts payable and $6.4 million in accrued expense and other liabilities. The increases in accounts receivable and accounts payable were primarily due to higher gross sales, while the decrease in inventory was due to the ASC 606 adjustment required in fiscal 2019 (refer to Note 1(u)).

Net cash used in investing activities during the three months ended November 29, 2019 was $5.1 million consisting primarily of purchases of property and equipment. Net cash used in investing activities during the three months ended November 30, 2018 was $13.4 million consisting primarily of purchases of property and equipment.  

Net cash used in financing activities during the three months ended November 29, 2019 was $4.0 million, consisting primarily of $6.4 million long-term debt payments for both the Amended Credit Agreement and the BNDES Credit Agreement, partially offset by $2.4 million proceeds from issuance of ordinary shares from share option exercises and employee share purchase plans. Net cash used in financing activities during the three months ended November 30, 2018 was $1.7 million consisting primarily of $3.4 million proceeds from issuance of ordinary shares from share option exercises and employee share purchase plans, partially offset by $1.7 million long-term debt payments for the BNDES Credit Agreements.

There have been no material changes to contractual obligations previously disclosed in our Annual Report.

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Off-Balance Sheet Arrangements

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not have any undisclosed borrowings or debt, and we have not entered into any synthetic leases. We are, therefore, not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial conditions, net sales or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

Recent Accounting Pronouncements

See Note 1 of our Notes to Unaudited Condensed Consolidated Financial Statements for information regarding the effect of recent accounting pronouncements on our financial statements.

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those listed below. We base our estimates on historical facts and various other assumptions that we believe to be reasonable at the time the estimates are made. Actual results could differ from those estimates.

Our critical accounting policies are as follows:

Our critical accounting policies are important to the portrayal of our financial condition and results of operations, and require us to make judgments and estimates about matters that are inherently uncertain. There have been no material changes to our critical accounting policies and estimates disclosed in “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” and Note 1, Overview, Basis of Presentation and Significant Accounting Policies, in each case in our Annual Report.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market rate risk includes risk of foreign currency exchange rate fluctuations, changes in interest rates and translation risk.

Foreign Exchange Risks

We are subject to inherent risks attributed to operating in a global economy. Our international sales and our operations in foreign countries subject us to risks associated with fluctuating currency values and exchange rates. Because a portion of our sales are denominated in U.S. dollars, increases in the value of the U.S. dollar could increase the price of our products so that they become relatively more expensive to customers in a particular country, possibly leading to a reduction in sales and profitability in that country. A significant portion of the sales of our products are denominated in Brazil reais. In addition, we have certain costs that are denominated in foreign currencies, and increases in the value of the U.S. dollar could result in increases in such costs that could have a material adverse effect on our results of operations. Beginning in the first quarter of fiscal 2019, we entered into forward contracts to hedge a portion of our foreign exchange risk in Brazil.

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As a result of our international operations, we generate a portion of our net sales and incur a portion of our expenses in currencies other than the U.S. dollar, particularly the Brazil reais. Approximately 35% and 51% of our net sales during the three months ended November 29, 2019 and November 30, 2018, respectively, originated in reais. We present our combined financial statements in U.S. dollars, and we must translate the assets, liabilities, net sales and expenses of a substantial portion of our foreign operations into U.S. dollars at applicable exchange rates. Consequently, increases or decreases in the value of the U.S. dollar may affect the value of these items with respect to our non-U.S. dollar businesses in our combined financial statements, even if their value has not changed in their local currency. Our customer pricing and material cost of sales are based on U.S. dollars, as is the global market for memory products. Accordingly, the impact of currency fluctuations to our consolidated income statements is primarily to our other costs of sales (i.e., non-material components) and our operating expenses as those items are typically denominated in local currency. Our consolidated income statements are also impacted by foreign currency gains and losses recorded in Other Expense arising from transactions denominated in a currency other than the functional currency of the respective subsidiary. These translations could significantly affect the comparability of our results between financial periods or result in significant changes to the carrying value of our assets, liabilities and equity. As a result, changes in foreign currency exchange rates impact our reported results.

During the three months ended November 29, 2019 and November 30, 2018, we recorded $0.9 million and $3.4 million, respectively, of foreign exchange losses.

Interest Rate Risk

We are subject to interest rate risk in connection with our long-term and short-term debt, including the $202.9 million aggregate balance under the term loans under the Amended Credit Agreement as of November 29, 2019. Although we did not have any revolving balances outstanding as of November 29, 2019, the revolving facility under the Amended Credit Agreement provides for borrowings of up to $50 million that would also bear interest at variable rates. Assuming that we will satisfy the financial covenants required to borrow and that the revolving loans under the Amended Credit Agreement were fully drawn and other variables are held constant, each 1.0% increase in interest rates on our variable rate borrowings would result in an increase in annual interest expense and a decrease in our cash flow and income before taxes of $2.5 million per year.

Item 4. Controls and Procedures

Limitation on Effectiveness of Controls

Any control system, no matter how well designed and operated, can provide only reasonable assurance as to the tested objectives. The design of any control system is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. The inherent limitations in any control system include the realities that judgments related to decision-making can be faulty, and that reduced effectiveness in controls can occur because of simple errors or mistakes. Due to the inherent limitations in a cost-effective control system, misstatements due to error may occur and may not be detected.

Evaluation of Disclosure Controls and Procedures

Management is required to evaluate our disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”). Disclosure controls and procedures are controls and other procedures designed to provide reasonable assurance that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include controls and procedures designed to provide reasonable assurance that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer as appropriate to allow timely decisions regarding required disclosure. Based on our management’s evaluation (with the participation of our principal executive officer and principal financial officer), our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were effective at a reasonable assurance level as of the end of the period covered by this report.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the quarter ended November 29, 2019, which were identified in connection with management’s evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Information with respect to this item may be found in Note 10, Commitments and Contingencies, in our Notes to Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q, which information is incorporated herein by reference. 

Item 1A. Risk Factors

There have been no material changes to the risks described in Part I, Item 1A, "Risk Factors," in our Annual Report on Form 10-K for our fiscal year ended August 30, 2019.  These risk factors could materially and adversely affect our business, financial condition and results of operations, and the market price of our ordinary shares could decline. These risk factors do not identify all risks that we face – our operations could also be affected by factors that are not presently known to us or that we currently consider to be immaterial to our operations. Due to risks and uncertainties, known and unknown, our past financial results may not be a reliable indicator of future performance and historical trends should not be used to anticipate results or trends in future periods.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Amended Credit Agreement

We are subject to certain restrictions with respect to the use of our working capital and our ability to pay dividends under our Amended Credit Agreement, as described in Note 7, Long-Term Debt—Amended Credit Agreement, in our Notes to Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q, which information is incorporated herein by reference.

Item 3. Defaults Upon Senior Securities

 

None.

Item 4. Mine Safety Disclosures

 

Not applicable.

 

 

Item 6. Exhibits

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

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