APPLIED OPTOELECTRONICS, INC. (AAOI) FY 2022 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and the accompanying notes appearing elsewhere in this Form 10-K. This discussion and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in “Risk Factors.” This section generally discusses the results of our operations for the year ended December 31, 2022 compared to the year ended December 31, 2021. For a discussion of the year ended December 31, 2021 compared to the year ended December 31, 2020, please refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2021, as amended.

Overview

We are a leading, vertically integrated provider of fiber-optic networking products. We target four networking end-markets: CATV, internet data centers, telecom and FTTH. We design and manufacture a range of optical communications products at varying levels of integration, from components, subassemblies and modules to complete turn-key equipment. In designing products for our customers, we begin with the fundamental building blocks of lasers and laser components. From these foundational products, we design and manufacture a wide range of products to meet our customers’ needs and specifications, and such products differ from each other by their end market, intended use and level of integration. We are primarily focused on the higher-performance segments within the CATV, internet data center, telecom and FTTH markets which increasingly demand faster connectivity and innovation. Our vertically integrated manufacturing model provides us several advantages, including rapid product development, fast response times to customer requests and control over product quality and manufacturing costs.

The four end markets we target are all driven by significant bandwidth demand fueled by the growth of network-connected devices, video traffic, cloud computing and online social networking. Within the CATV market, we benefit from a number of ongoing trends including the move to higher bandwidth networks among CATV service providers and the outsourcing of system design among CATV networking equipment companies. Within the internet data center market, we benefit from the increasing use of higher-capacity optical networking technology as a replacement for copper cables, particularly as speeds reach 10 Gbps and above, as well as the movement to open internet data center architectures and the increasing use of in-house equipment design among leading internet companies. In the FTTH market, we benefit from continuing PON deployments and system upgrades among telecom service providers. In the telecom market, we benefit from deployment of new high-speed fiber-optic networks by telecom network operators, including 5G networks.

In 2022, 2021 and 2020, our revenue was $222.8 million, $211.6 million, and $234.6 million, and our gross margin was 15.1%, 17.8%, and 21.5%, respectively. We have grown our annual revenue at a compound annual growth rate, or CAGR, of 11.0% between 2013 and 2022. In the years ended December 31, 2022, 2021 and 2020, we had net loss of $66.4 million, $54.2 million, and $58.5 million, respectively. At December 31, 2022 and 2021, our accumulated deficit was $209.1 million and $142.7 million, respectively. In 2022, we earned 53.0% of our total revenue from the CATV market and 34.6% of our total revenue from the internet data center market.

We sell our products to leading OEMs in the CATV, telecom, and FTTH markets as well as internet data center operators. In 2022, revenue from the CATV market, internet data center market, telecom market and FTTH markets provided 53.0%, 34.6%, 11.1%, and 0.1% of our revenue, respectively, compared to 44.6%, 46.1%, 7.7%, and 0.5% of our 2021 revenue, respectively. In 2022, our key customers in the CATV market included, ATX, Cisco, and CommScope. In 2022, 2021, and 2020, ATX accounted for 47.3%, 25.6%, and 3.7% of our revenue, Cisco accounted for 1.9%, 11.9% and 7.5% of our revenue and CommScope accounted for 1.7%, 3.3% and 2.1% of our revenue, respectively. Data center market included, Microsoft, a U.S. based large datacenter operator and a U.S. based NEM company. In 2022, 2021, and 2020, Microsoft accounted for 18.4%, 14.11%, and 38.3% of our revenue, the U.S. based large datacenter operator accounted for 5.9%, 8.3%, and 8.0% of our revenue, and the U.S. based NEM company accounted for 3.6%, 7.2% and 7.9% of our revenue, respectively.

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In 2022, our revenue increase of 5.3% over the prior-year was driven primarily by strong demand in CATV product sales arising from products with architecture improvements to enable delivery of additional bandwidth to consumers. The increase in bandwidth demand was particularly acute in the upstream direction, and sales of products associated with increased return-path bandwidth were notably strong in the year. The increase was offset by the decrease of data center sales related to inventory normalization and demand decrease. Based on customer forecasts and order backlog we believe that this elevated CATV demand will likely continue into 2023.

We expect continued sales of our 40 Gbps and 100 Gbps products in 2023, and we expect that sales of 100 Gbps products will likely exceed sales of 40 Gbps products. However, quarter-to-quarter results may show considerable variability as is usual in a period of technology transition. Similar to revenue, our gross margins can fluctuate materially depending on a variety of factors including average selling price changes, product mix, global supply chain situation, raw material cost reduction or increase, manufacturing utilization rate and changes in manufacturing efficiency. Furthermore, we are continuing to monitor and assess the effects of the coronavirus outbreak on our commercial and manufacturing operations, including any impact on our revenue in 2023.

Our sales model focuses on direct engagement and close coordination with our customers to determine product design, qualifications, performance and price. Our strategy is to use our direct sales force to sell to key accounts and to expand our use of distributors for increased coverage in certain international markets and certain domestic market segments. We have direct sales personnel that cover the U.S., Taiwan and China focusing primarily on major OEM customers and internet data center operators. Throughout our sales cycle, we work closely with our customers to qualify our products into their product lines. As a result, we strive to build strategic and long-lasting customer relationships and deliver products that are customized to our customers’ requirements.

Our business depends on winning competitive bid selection processes to develop components, systems and equipment for use in our customers’ products. These selection processes are typically lengthy, and as a result our sales cycles will vary based on the level of customization required, market served, whether the design win is with an existing or new customer and whether our solution being designed in our customers’ product is our first generation or subsequent generation product. We do not have any long-term purchase commitments (in excess of one year) with any of our customers, most of whom purchase our products on a purchase order basis, however, once one of our solutions is incorporated into a customer’s design, we believe that our solution is likely to continue to be purchased for that design throughout that product’s life cycle because of the time and expense associated with redesigning the product or substituting an alternative solution.

In 2022, 2021 and 2020, we had 12, 20, and 30 design wins, respectively. We define a design win as the successful completion of the evaluation stage, where our customer has tested our product, verified that our product meets substantially all of their requirements and has informed us that they intend to purchase the product from us. Although we believe that our ability to obtain design wins is a key strength and can provide meaningful and recurring revenue, an increase or decrease in the mere number of design wins does not necessarily correlate to a likely increase or decrease in revenue, particularly in the short term. As such, the number of design wins we achieve on a quarterly or annual basis and any increase or decrease in design wins will not necessarily result in a corresponding increase or decrease in revenue in the same or immediately succeeding quarter or year. For example, if our total number of design wins in an annual or quarterly period increases or decreases compared to the total number of design wins in a prior period, this does not necessarily mean that our revenue in such period will be higher or lower than our revenue in the prior period. In fact, our experience is that some design wins result in significant revenue and some do not, and the timing of such revenue is difficult to predict as it depends on the success of the end customer’s product that uses our components. Thus, some design wins result in orders and significant revenue shortly after the design win is awarded and other design wins do not result in significant orders and revenue for several months or longer after the initial design win (if at all). We do believe that over a period of years the collective impact of design wins correlates to our overall revenue growth.

Divestiture Agreement with Yuhan Optoelectronic Technology (Shanghai) Co., Ltd

On September 15, 2022, we entered into a definitive agreement and announced the planned divesture to sell the manufacturing facilities in the People’s Republic of China ("PRC") and certain assets related to our transceiver business and multi-channel optical sub-assembly products to Yuhan Optoelectronic Technology (Shanghai) Co., Ltd. ("Purchaser"), which is a company incorporated in the PRC. The transaction is expected to close within 2023 subject to the satisfaction of certain closing conditions, including the CFIUS approval.

The purchase price for this transaction will be an amount equal to the $150 million USD equivalent of Renminbi less a holdback amount. Prior to the closing of this transaction, the Company anticipates investing an amount equal to between 4% and 10% of the estimated proceeds from the transaction in exchange for a 10% equity interest in the Purchaser. The proceeds from the transaction will enable the Company to make strategic investments in higher margin and higher growth opportunities. By exiting the transceiver market, the Company will focus its resources on its CATV business and manufacturing lasers and laser components for the CATV, datacenter, telecom and FTTH markets.

Our management has performed an evaluation as required by ASC-360-10-45-9 to determine whether to classify certain of our assets and liabilities as held for sale as of December 31, 2022. ASC 360 requires that a company classifies a business as held for sale in the period in which management commits to a plan to sell the business, the business is available for immediate sale in its present condition, an active program to complete the plan to sell the business is initiated, the sale of the business within one year is probable and the business is being marketed at a reasonable price in relation to its fair value. Although we have announced the execution of a definitive purchase agreement regarding the Divestiture, completion of this transaction is not certain for reasons that include the fact that the proposed sale is subject to regulatory approval in the US and China, the timing and likelihoodof which is uncertain and beyond our control, and the fact that we cannot be certain that the buyer will not request modification of terms within the definitive purchase agreement. As a result, we have concluded that at the present time the business is not "available for immediate sale" under the meaning defined in ASC 360 and therefore none of our assets or liabilities should be classified as held for sale.

COVID-19 Pandemic

The COVID-19 pandemic has had, and continues to have, a significant impact around the world. We are subject to risks and uncertainties as a result of the COVID-19 pandemic. The extent of the impact of the COVID-19 pandemic on our business is highly uncertain and difficult to predict as COVID-19 continues to spread around the world. In March 2020, we instituted travel restrictions and implemented sanitation and disinfection procedures to safeguard the health and safety of our employees which continue today. With increased vaccinations and the potential reduction of infections, we implemented procedures for a safe return to the office environment for all of our employees in 2021. China experienced the world's largest COVID-19 surge of the pandemic in December 2022 after the end of the zero-COVID policy. Yet there is minimum impact to the labor force in China due to less government's restrictions on quarantine and testing.

The spread of COVID-19 has impacted our supply chain operations through restrictions, reduced capacity and shutdown of business activities by suppliers whom we rely on for sourcing components and materials and third-party partners whom we rely on for manufacturing, warehousing and logistics services. Our supply chain restrictions due to COVID-19 have improved during the latter part of 2022, and we continue to expect improvements in 2023.

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Factors Affecting Our Performance

Increasing Consumer Demand for Bandwidth. Bandwidth demand in all of our target markets is driving service provider investment in new equipment and in turn generating demand for our products. Increasingly, optical networking technologies are being incorporated into networking equipment, replacing legacy copper-based networking technologies. This shift to optical networking solutions benefits us as a provider of those solutions.

Pricing, Product Cost and Margins. Our products are sold in a highly competitive marketplace, and in many cases our products are only minimally differentiated from those of our competitors.  In addition, our sales are heavily concentrated with a small number of end customers.  As a result, there is strong pricing pressure across many of our product lines.  We have addressed this strong pressure in several ways:

Our product pricing is established when the product is initially introduced to the market, and thereafter through periodic negotiations with customers. We generally do not agree to periodic automatic price reductions. Furthermore, due to the dynamics in the CATV market and the value of our outsourced design services to our customers, we believe we face less downward price pressure than many of our competitors in this market. We sell a wide variety of products among our four target markets and our gross margin is heavily dependent in any quarter on the product mix achieved during that period as well as any price changes that we have agreed upon with our customers.

Customer Concentration within End Markets. Historically, our revenue has been significantly concentrated within the data center market, and starting from 2021, our revenue tends to be split between CATV market and data center market. Moreover, within these markets, revenue tends to be concentrated among a small number of customers. In the last couple years, we have taken several actions to increase the diversity of our customer base. These actions include hiring additional sales staff to improve our ability to serve new customers and introduction of new products that we believe will appeal to new customers. Furthermore, we have developed additional original design manufacturer, or ODM, relationships with customers in each of our target markets which should enable us to diversify our revenue base. We had two and three customers that accounted for more than 10% of our revenue in 2022 and 2021, respectively.

Product Development. We invest heavily to develop new and innovative products. The majority of our research and development expense is allocated to product development, usually with a specific customer and customer platform in mind. We believe our close coordination with our customers regarding their future product requirements enhances the efficiency of our research and development expenditures.

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Discussion of Financial Performance

Revenue

We generate revenue through the sale of our products to equipment providers for the CATV, internet data center, telecom, FTTH and other markets. We derive a significant portion of our revenue from our top ten customers, and we anticipate that we will continue to do so for the foreseeable future. The following chart provides the revenue contribution from each of the markets we serve for the years 2022, 2021 and 2020, as well as the corresponding percentage of our total revenue for each period (in thousands, except percentages):

In 2022, 2021 and 2020, our top ten customers represented 87.2%, 84.7%, and 84.3% of our revenue, respectively.

Revenue is recognized when obligations under the terms of a contract with our customer are satisfied; generally this occurs with the transfer of control of products or services. Revenue is measured as the amount of consideration we expect to receive in exchange for transferring products or providing services. A majority of our annual sales are denominated in U.S. dollars, but some sales from our Taiwan location and China-based subsidiary are denominated in NT dollars and RMB, respectively. For the year ended December 31, 2022, 23.0% of our total revenue was manufactured at our China-based subsidiary, with $10.5 million denominated in RMB and 73.7% of our total revenue was from products manufactured at our Taiwan-based facility, with no revenue denominated in NT dollars. We expect a similar portion of our sales to be denominated in foreign currencies in 2023.

Cost of goods sold and gross margin

Our cost of goods sold is impacted by variances arising from changes in yields and production volume, as well as increases or decreases in the cost of raw materials used in production. We typically experience lower yields and higher associated costs on new products, especially during the initial phase of the production. For our mature products, we can experience lower yields and higher production costs if customer requirements change or if we experience manufacturing difficulties or quality issues during our production process. Notwithstanding the foregoing, however, in general for our mature products our cost of goods sold for a particular product declines over time as a result of increasing efficiencies in the manufacturing processes, or supply cost declines, as well as yield improvements and testing enhancements.

We manufacture products in three of our four facilities located in the U.S., Taiwan and China. Generally, laser chips and optical components are manufactured in our Sugar Land facility, and optical components, subassemblies and optical equipment are manufactured in our Taiwan and China facility. Because of our vertical integration model, we generally utilize our own optical component products in our semi-finished and finished goods that we sell between and among our respective manufacturing operations. We base those internal sales upon established transfer pricing methodologies. However, we eliminate all of those internal sales, and cost of goods sold transactions, to arrive at total revenue and cost of goods sold on a consolidated basis.

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We have a global set of suppliers to help balance considerations related to product availability, quality and cost. Components of our cost of goods sold are denominated in U.S. or NT dollars or RMB, depending upon the manufacturing location.

Gross profit as a percentage of total revenue, or gross margin, has been and is expected to continue to be affected by a variety of factors, including the introduction of new products, production volumes, the mix of products sold, the geographic region in which products are sold, changes in the cost and volumes of materials purchased from our suppliers, changes in labor costs, changes in overhead costs, reserves for excess and obsolete inventories and changes in the average selling prices of our products. Although our overall gross margins over the past three years have been between 15.1% and 21.5%, our gross margins vary more broadly on a product-by-product basis. Our newer and more advanced products typically have higher average selling prices and higher gross margins; however, until the product volumes scale, the gross margin from newer and advanced products may initially be lower. Within our markets, we may sell similar products to different geographic regions at different prices, and therefore realize different gross margins among those similar products. Our strategy is to improve our gross margins through vertical integration such as utilization of our own laser chips and optical sub-components in our solutions. We expect that our gross margins are likely to continue to fluctuate from quarter to quarter because of the variety of products we sell and the relative product mix within a quarter.

Operating expenses

Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs are the most significant component of operating expenses and include salaries, benefits, bonuses and share-based compensation. With regard to sales and marketing expense, personnel costs also include sales commissions.

Research and development.

Research and development, or R&D, expense consists primarily of personnel costs, including share-based compensation for R&D personnel, and R&D work orders (that include material, direct labor and allocated overhead), as well as allocated development costs, such as engineering services, software and hardware tools, depreciation of capital equipment and facility costs. We record all research and development expense as incurred. Customers rely upon us to assist them with the development of new products and modification of existing products because of our extensive optical design and manufacturing expertise. We work closely with our customers in the critical design phase of product development and are occasionally reimbursed for some of these development efforts. We expect research and development expense to increase on a dollar basis, but will likely decrease as a percentage of our revenue to the extent that revenue increases over time.

Sales and marketing.

Sales and marketing expense consists primarily of personnel costs, including share-based compensation for our sales and marketing personnel, as well as travel and trade show expense, shipping and tariff expense, sales commissions and the allocation of overall corporate services and facility costs. We sell our products to customers who either incorporate our products into their offering or resell our products to end customers. Because we sell to a limited number of well-established customers, we employ a limited number of sales professionals who are able to cover large markets. We compensate our sales staff through base salary and commissions, with base salary being the largest component of overall compensation. Total sales commissions to employees amounted to less than one percent of our revenue in 2022, 2021 and 2020. Additionally, we pay commissions to third parties on certain product lines and identified customers, which also amounted to less than one percent of our revenue in 2022, 2021 and 2020. As such, our sales and marketing expense does not directly increase with revenue. In the future, we expect sales and marketing expense to increase on a dollar basis as we incrementally increase our overall sales activities, but expect our sales and marketing expense to decline as a percentage of revenue, to the extent our revenue increases over time.

General and administrative.

General and administrative expense consists primarily of personnel costs, including share-based compensation, primarily for our finance, human resources, legal and information technology personnel and certain executive officers, as well as professional services costs related to accounting, tax, banking, legal and information technology services, depreciation of capital equipment and facility costs. We expect general and administrative expense to increase as we continue to grow in both size and complexity as a public company. We expect rising costs including increased audit and legal fees, costs to comply with rules and regulations applicable to companies listed on a national stock exchange, as well as investor relations expense and higher insurance premiums. In the future, we expect general and administrative expense to increase on a dollar basis but to decline as a percentage of revenue, to the extent that our revenue increases over time.

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Other income (expense)

Interest income consists of income earned on our cash, cash equivalents and short-term investments. Interest expense consists of amounts paid for interest on our short-term and long-term debt borrowings, and convertible senior notes.

Other income (expense), net is primarily made up of government subsidized income, extinguishment of debt and foreign currency transaction gains and losses. The functional currency of our China subsidiary is the RMB and the foreign currency transaction gains and losses of our China subsidiary primarily result from their transactions in U.S. dollars. The functional currency of our Taiwan location is the NT dollar and the foreign currency transaction gains and losses of our Taiwan location primarily result from their transactions in U.S. dollars.

Income taxes

We are a U.S. registered company and are subject to income taxes in the U.S. We also operate in a number of countries throughout the world, including Taiwan and China. Consequently, our effective tax rate is impacted by the geographic distribution of our earnings or losses and the tax laws and regulations in each geographical region. We expect that our income taxes will vary in relation to our profitability and the geographic distribution of our profits. In 2022 and 2021 our effective tax rate was (0.0%). In 2020 our effective tax rate was (14.1%).

Our wholly owned subsidiary, Global Technology, Inc., has received preferential tax concessions in China as a national high-tech enterprise. In March 2007, China’s parliament enacted the PRC Enterprise Income Tax Law, or the EIT Law, under which, effective January 1, 2008, China adopted a uniform income tax rate of 25% for all enterprises including foreign invested enterprises. Global was recognized as a national high-tech enterprise in 2008 and was entitled to a 15% tax rate for a three-year period. Global renewed its national high-tech enterprise certificate in 2011, 2014, 2017 and 2020, extending its three-year tax preferential status through December 2023.

For the years ended December 31, 2022 and 2021, we had $0.2 million and $0.2 million, respectively, of unrecognized tax benefits related to U.S. tax benefits recognized for which we do not meet the more likely than not threshold.

See additional information regarding income taxes in Note O, included in Part II, Item 8 of this Form 10-K.

Seasonality

We are uncertain whether the demand for our CATV, internet data center, telecom and FTTH products is seasonal, as our sales data does not indicate a significant trend with respect to these products. We began to manufacture a meaningful quantity of CATV and internet data center products in our Ningbo, China factory in 2017 and 2020, respectively. This factory experiences a lengthy shut-down associated with the Lunar New Year holiday which occurs in Q1 of each year. In addition to the factory shut-down, it is also common for employees in the factory to fail to return to work following resumption of operations. In the years 2022, 2021, and 2020, the percentage of employees in our China factory who resigned or were terminated during Q1, relative to the average number of employees during the quarter was 66.1%, 35.9%, and 43.8%, respectively.   We believe that the turnover in 2020 was higher than usual due to the COVID-19 pandemic which caused travel restrictions, additional health check requirements, and a lengthy shutdown of operations in Ningbo.  As a result of employee turnover, we must hire and train replacement employees. These replacement employees require a period of training and improvement, and this impacts the quantity of products we can produce in the quarter. The combined effect of the factory shut-down and employee turnover in the quarter may also contribute to negative seasonality in Q1.

Our gross margin varies quarter to quarter and varies primarily due to the product mix in a particular quarter, as well as from the level of manufacturing efficiencies, production yields (particularly in the laser chip fabrication process) and overall supply costs.

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Results of Operations

The following table sets forth our results of operations for the periods presented as a percentage of our revenue for those periods. The period-to-period comparison of our financial results is not necessarily indicative of our financial results to be achieved in future periods.

Comparison of Years Ended December 31, 2022 and 2021

Revenue

We generate revenue through the sale of our products to equipment providers and network operators for the CATV, internet data center, telecom, FTTH and other markets. We derive a significant portion of our revenue from our top ten customers, and we anticipate that we will continue to do so for the foreseeable future. The following charts provide the revenue contribution from each of the markets we served for the years ended December 31, 2022 and 2021 (in thousands, except percentages):

Revenue increased by $11.2 million or 5.3% from 2021 to 2022. The increase was driven primarily by strong demand in CATV product sales arising from products with architecture improvements to enable delivery of additional bandwidth to consumers. The increase in bandwidth demand was particularly acute in the upstream direction, and sales of products associated with increased return-path bandwidth were notably strong in the year. The increase was offset by the decrease of data center sales related to inventory normalization and demand decrease. Based on customer forecasts and order backlog we believe that this elevated CATV demand will likely continue into 2023.

In the years ended December 31, 2022 and 2021, our top ten customers represented 87.2% and 84.7% of our revenue, respectively. We believe that diversifying our customer base is critical for our future success, since reliance on a small number of key customers makes our ability to forecast future results dependent upon the accuracy of the forecasts we receive from those key customers.

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Cost of goods sold and gross margin

Cost of goods sold increased by $15.3 million, or 8.8%, from 2021 to 2022, primarily due to a 5.3% increase in sales over the prior year. The decrease in gross margin for the year ended December 31, 2022 compared to the same period ended December 31, 2021 was primarily the result of changes in the mix of products in our CATV and datacenter segments. In addition, we also experienced higher costs of certain raw materials and global supply chain disruptions due to COVID-19 closures of ports and factories in Asia (see the section above on the COVID-19 pandemic for more details of these challenges).

Operating expenses

Research and development expense

Research and development expense decreased $5.0 million, or 12.1% from 2021 to 2022. Research and development costs consist of R&D work orders, R&D material usage and other project related costs related to 100 Gbps, 200/400 Gbps data center products, DOCSIS 3.1 capable CATV products, including remote-PHY products and 1.2 GHz-capable amplifier products,  and other new product development, and depreciation expense resulting from R&D equipment investments. The decreases were primarily due to less R&D work orders, renovation depreciation ended in October 2021 in China site and less indirect materials usage.

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Sales and marketing expense

Sales and marketing expense decreased by $1.2 million, or 10.8%, from 2021 to 2022. These decreases were primarily due to the less sales from certain customers which include commission incentives, and partially offset by an increase in tradeshow expenses in 2022 due to the increase in number of tradeshows attended because of  less COVID-19 restrictions.

General and administrative expense

General and administrative expense increased by $4.3 million, or 10.1%, from 2021 to 2022. These increases were primarily due to the idle asset allocation from production to general and administrative section and additional bonus expense in 2022 for meeting the target.

Other income (expense), net

Interest income increased by $0.1 million, or 80.0% from 2021 to 2022. The changes are similar to expected rates of fluctuation with the interest rates and cash balances.

Interest expense increased by $0.7 million, or 12.4% from 2021 to 2022. The increase was primarily due to the debt balance increase and the interest rate fluctuation during the year.

Other income decreased by $9.4 million, or 114.8% from 2021 to 2022.This decrease was primarily due to the $6.23 million government's PPP Loan forgiveness stimulus obtained in year 2021. The remaining decrease was mainly due to the foreign exchange loss.

Benefit (provision) for income taxes

Our income tax provision consists of U.S. income tax, state taxes, and Taiwan and China income tax recorded during the periods. Our effective tax rate is affected by recurring items, such as tax rates in state and foreign jurisdictions and the relative amounts of income we earn in those jurisdictions.

We recorded no federal tax expense for the years ended December 31, 2022 and December 31, 2021. The income tax expense in the years ended December 31, 2022 and December 31, 2021 was primarily related to the state tax provision and the recording of a valuation allowance on our deferred tax assets.

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Liquidity and Capital Resources

As of December 31, 2022, we had $13.3 million of unused borrowing capacity from all of our loan agreements. As of December 31, 2022, our cash, cash equivalents, restricted cash and short-term investments totaled $35.6 million. Cash and cash equivalents are held for working capital purposes and are invested primarily in money market or time deposit funds.

On October 24, 2019, we filed a Registration Statement on Form S-3 with the Securities and Exchange Commission, which was declared effective on January 9, 2020, providing for the public offer and sale of certain securities of the Company from time to time, at our discretion, up to an aggregate amount of $250 million.

On February 28, 2020, we entered into an Equity Distribution Agreement with Raymond James & Associates, Inc. (the “Sales Agent”) pursuant to which the Company may issue and sell shares of the Company’s common stock having an aggregate offering price of up to $55 million (the “Initial ATM Offering”), from time to time through the Sales Agent. In January 2021, the Company completed its Initial ATM Offering and sold 5.9 million shares at a weighted average price of $9.12 per share, providing proceeds of $53.9 million, net of expenses and underwriting discounts and commissions.

On February 26, 2021, we entered into another Equity Distribution Agreement (the “Agreement”) with the Sales Agent pursuant to which the Company may issue and sell shares of the Company’s common stock, par value $0.001 per share (the “Shares”) having an aggregate offering price of up to $35 million (the “Second ATM Offering”), from time to time through the Sales Agent. Upon delivery of a placement notice and subject to the terms and conditions of the Agreement, sales, if any, of the Shares will be made through the Sales Agent in transactions that are deemed to be “at the market” offerings as defined in Rule 415 of the Securities Act of 1933, as amended (the “Securities Act”), including sales made through the facilities of the Nasdaq Global Market, the principal trading market for the Company’s common stock, on any other existing trading market for the Company’s common stock, to or through a market maker or as otherwise agreed by the Company and the Sales Agent. In the placement notice, the Company will designate the maximum number of Shares to be sold through the Sales Agent, the time period during which sales are requested to be made, the minimum price for the Shares to be sold, and any limitation on the number of Shares that may be sold in any one day. Subject to the terms and conditions of the Agreement, the Sales Agent will use its commercially reasonable efforts to sell Shares on the Company’s behalf up to the designated amount specified in the placement notice. The Company has no obligation to sell any Shares under the Agreement and may at any time suspend offers and sales of the Shares under the Agreement.

The Agreement provides that the Sales Agent will be entitled to compensation of up to 2% of the gross sales price of the Shares sold through the Sales Agent from time to time. The Company has also agreed to reimburse the Sales Agent for certain specified expenses in connection with the registration of Shares under state blue sky laws and any filing with, and clearance of the offering by, the Financial Industry Regulatory Authority Inc., not to exceed $10,000 in the aggregate, and any associated application fees incurred. Additionally, if the Agreement is terminated under certain circumstances, and the Company fails to sell a minimum amount of the Shares as set forth in the Agreement, then the Company has agreed to reimburse the Sales Agent for reasonable out-of-pocket expenses, including the reasonable fees and disbursements of counsel incurred by the Sales Agent, up to a maximum of $30,000 in the aggregate. The Company agreed to indemnify the Sales Agent against certain liabilities, including liabilities under the Securities Act, or to contribute to payments that the Sales Agent may be required to make because of any of those liabilities.

In March 2021, we commenced sales of common stock through the Second ATM Offering. The details of the shares of common stock sold through the Second ATM Offering through December 31, 2022 are as follows (in thousands, except shares and weighted average per share price):

As of December 31, 2022, the total gross sales were $2.2 million and thus remaining amount of common stock we have available to sell under the Second ATM Offering is $32.8 million.

On January 5, 2023, the Company filed a Registration Statement on Form S-3 with the Securities and Exchange Commission, which has not yet been declared effective, providing for the public offer and sale of certain securities of the Company from time to time, at our discretion, up to an aggregate amount of $185 million. Pursuant to Rule 415(a)(6) under the Securities Act, the securities registered pursuant to this registration statement include unsold securities previously registered for sale pursuant to our previously filed registration statement on Form S-3, which became effective on January 9, 2020.

On March 5, 2019, the Company issued $80.5 million of 5% convertible senior notes due 2024, bearing interest at a rate of 5% per year maturing on March 15, 2024 (the "Notes"), unless earlier repurchased, redeemed or converted in accordance with their terms. The sale of the Notes generated net proceeds of $76.4 million, after expenses. Also refer to Note L “Convertible Senior Notes” to the consolidated financial statements for further discussion of the Notes.

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The table below sets forth selected cash flow data for the periods presented (in thousands):

Operating activities

In 2022, net cash used in operating activities was $14.0 million. Net cash used in operating activities consisted of our net loss of $66.4 million, after the exclusion of non-cash items of $40.5 million, an increase in accounts receivable from our customers of $12.7 million and an increase in other current assets of $2.4 million. These cash decreases were offset by a decrease of notes receivable of $7.8 million, decrease in inventory of $1.2 million, increase in accounts payable to our vendors of $13.0 million and increase in accrued liabilities of $5.3 million.

In 2021, net cash used in operating activities was $11.6 million. Net cash used in operating activities consisted of our net loss of $54.2 million, after the exclusion of non-cash items of $36.6 million, an increase in accounts and notes receivable from our customers of $14.6 million and a decrease in accrued liabilities of $3.1 million. These cash decreases were offset by a decrease in inventory of $15.8 million and increase in accounts payable to our vendors of $7.1 million.

In 2020, net cash used in operating activities was $44.0 million. Net cash used in operating activities consisted of our net loss of $58.5 million, after the exclusion of non-cash items of $48.9 million, an increase in accounts receivable from our customers of $8.4 million and an increase in inventory of $23.7 million and decrease in accounts payable to our vendor of $3.3 million.

Investing activities

Our investing activities consisted primarily of capital expenditures and purchases of intangible assets.

In 2022, net cash used in investing activities was $3.8 million. The net cash used consisted of spending on purchase and prepaid of additional property, plant and equipment of $3.7 million and purchase of intangible assets of $0.5 million.

In 2021, net cash used in investing activities was $10.5 million. The net cash used consisted of spending on purchase and prepaid of additional property, plant and equipment of $10.2 million.

In 2020, net cash used in investing activities was $19.3 million. The net cash used consisted of spending on China factory construction, purchase and prepaid of additional property, plant and equipment of $19.1 million.

Financing activities

Our financing activities have historically consisted primarily of proceeds from the issuance of common stock and arrangements with various commercial lenders.

In 2022, our financing activities provided $10.8 million in cash. This increase in cash was due to $12.2 million of net proceeds from line of credit borrowing, $5.1 million of net proceeds from bank acceptance payable and $1.2 million of net proceeds from our At-The-Market (ATM) Offering. These activities were offset by $7.3 million debt repayment and $0.5 million related to tax withholding associated with employee share-based compensation.

In 2021, our financing activities provided $14.1 million in cash. This increase in cash was due to $15.4 million of net proceeds from our At-The-Market (ATM) Offering. These activities were offset by $0.3 million net repayments to acceptances payable and bank debt, and $1.0 million related to tax withholding associated with employee share-based compensation.

In 2020, our financing activities provided $47.4 million in cash. This increase in cash was due to $39.2 million of net proceeds from our At-The-Market (ATM) Offering, $6.2 million proceeds from PPP term loan, and $3.4 million net proceeds from acceptances payable and bank debt.

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Loans and commitments

We have lending arrangements with several financial institutions. In the U.S., we entered a Loan Security and Guarantee Agreement with CIT Northbridge Credit, LLC in November 2022 and fully repaid the loan with Truist Bank. The line of credit contains financial covenants that may limit the amount and types of debt that we may incur. As of December 31, 2022, we were in compliance with these covenants.

In Taiwan, the Company has fully repaid the finance agreement with Chailease Finance Co, Ltd. for Prime World's Taiwan Branch. In China, we have a revolving line of credit with Shanghai Pudong Development Bank Co., Ltd and a credit facility with China Zheshang Bank Co., Ltd. for our China subsidiary, Global.

As of
December 31, 2022
, we had $13.3 million of unused borrowing capacity.

On March 5, 2019, the Company issued $80.5 million of 5% convertible senior notes due 2024. The Notes will mature on March 15, 2024, unless earlier repurchased, redeemed or converted in accordance with their terms.

See Note K “Notes Payable and Long-term Debt” and Note L “Convertible Senior Notes” of our Consolidated Financial Statements for a description of our notes payable and long-term debt and convertible senior notes.

China factory construction

On February 8, 2018, we entered into a construction contract with Zhejiang Xinyu Construction Group Co., Ltd. for the construction of a new factory and other facilities at our Ningbo, China location.  Construction costs for these facilities under this contract are estimated to total approximately $27.5 million. As of December 31, 2022, construction of the building shell is complete, and approximately $27.4 million of this total cost has been paid and the remaining portion will be paid in yearly installments for three years after final inspection. We anticipate additional expenses for building improvements to the factory and we are in the process of evaluating the timing of these expenditures and obtaining bids for any such work. Based on forecasts, we believe the factory will be placed in service in the second half of 2023 after the construction is completed for the building interior. Property will be transferred from construction in progress to building and improvement at that time.

Future liquidity needs

We believe that our existing cash and cash equivalents, cash flows from our operating activities, and available credit will be sufficient to meet our anticipated cash needs for the next 12 months. Our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support our research and development efforts, the expansion of our sales and marketing activities, the introduction of new and enhanced products, changes in our manufacturing capacity and the continuing market acceptance of our products.  In the event we need additional liquidity, we will explore additional sources of liquidity. These additional sources of liquidity could include one, or a combination, of the following: (i) issuing equity or debt securities, (ii) incurring indebtedness secured by our assets and (iii) selling product lines, other assets and/or portions of our business. There can be no guarantee that we will be able to raise additional funds on terms acceptable to us, or at all.

Contractual Obligations and Commitments

We have outstanding notes payable with varying maturities. As of December 31, 2022, our notes payable had an amount of $57.1 million, and the entire balance is within 12 months. Further information regarding our note payable is provided in Note K Notes Payable and Long-Term Debt in the Notes to Consolidated Financial Statements in this Form 10-K. We also have a fixed-rate convertible senior note. As of December 31, 2022, our convertible senior note had an aggregate principle amount of $80.5 million and future interest payments associated with our senior notes totaled $6.0 million. Further information regarding our convertible senior notes is provided in Note L – Convertible Senior Notes in the Notes to Consolidated Financial Statements in this Form 10-K. In addition, we have operating and financial lease for certain property and equipment with an expected term at the commencement date of more than 12 months. As of December 31, 2022, the future minimum payments required under these leases totaled $7.3 million, with $1.2 million payable within 12 months. Further information regarding our leases is provided in Note D – Leases to Consolidated Financial Statements in this Form 10-K.

Inflation

The annual inflation rate in the US and Taiwan accelerated more than 7% in 2021 and closed out at 6.5% and 2.71% in December 2022 for US and Taiwan, respectively. The cost of inflation was reflected in increases in shipping costs, labor rates, and in costs of some raw materials; we believe these increases are related to the COVID-19 pandemic (please refer to our discussion on COVID-19 in the MD&A section of this Form 10-K), however we cannot be sure when or if prices will return to pre-pandemic levels. Compared to other major economies in the world, China has a stable level of inflation, which has not had a significant impact on our sales or operating results. However, there is no guarantee that we may increase selling prices or reduce costs to fully mitigate the effect of inflation on our costs, which may adversely impact our sales margins and profitability.

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Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, expenses and cash flows, and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, share-based compensation expense, impairment analysis of goodwill and long-lived assets, valuation of inventory, warranty liabilities and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

We believe that of our significant accounting policies, which are described in Note B to our consolidated financial statements appearing elsewhere in this Form 10-K, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, we believe these are the most critical to fully understand and evaluate our financial condition and results of operations.

Long-lived assets

We evaluate the carrying value of long-lived assets for potential impairment when we determine a triggering event has occurred, or whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. When indicators exist, recoverability of assets is measured by a comparison of the carrying value of the asset group to the estimated undiscounted future net cash flows expected to be generated by the asset. Examples of such triggering events include a significant disposal of a portion of such assets, an adverse change in the market involving the business employing the related asset, a significant decrease in the benefits realized from an acquired business, difficulties or delays in integrating the business, and a significant change in the operations of an acquired business. If such assets are determined not to be recoverable we perform an analysis of the fair value of the asset group and will recognize an impairment loss when the fair value is less than the carrying amount of such assets. The fair value, based on reasonable and supportable assumptions and projections, require subjective judgments. Depending on the assumptions and estimates used, the fair value projected in the evaluation of long-lived assets can vary within a range of outcomes. We consider the likelihood of possible outcomes in determining the best estimate for the fair value of the assets. We did not record any asset impairment charges in 2022, 2021 and 2020.

Valuation of inventories

Inventories are stated at the lower of cost (average-cost method) or net realizable value. Work in process and finished goods includes materials, labor and allocated overhead. We assess the valuation of our inventory on a periodic basis and provide an allowance for the value of estimated excess and obsolete inventory based on estimates of future demand. Inventory reserves are recorded to account for the excess and obsolete inventory combined with the lower of cost or net realizable value assessments. To develop the reserve, we developed certain percentages that determine the extent of inventory reserve adjustments based on the age of the inventory. Such percentages were determined through analysis of the inventory to determine each product's lifespan, a review historical write-offs or scrapped inventory, and an assessment by product engineers of the possibility of obsolescence for each product.

During the years ended December 31, 2022, 2021 and 2020, we recorded excess and obsolete inventory reserve charges of $4.9 million, $3.9 million, and $3.9 million, respectively. For the years December 2022, 2021 and 2020, the direct inventory write-offs related to scrap, discontinued products and damaged inventories were $10.4 million, $16.8 million, and $20.4 million, respectively.

We have an accounting policy to record a reserve for inventory encompassing the value of excess or obsolete items combined with the lower of cost or net reliable value. We considered the following factors in our determination of the appropriate reserve level: how often we buy material in bulk; the overall market value of raw material, semi-finished goods and finished goods across our varied product lines and within markets; changes in expected demand for our products; the change in valuations historically; the determined safety stock for key customers; and the likelihood of postponement in delivery schedules for materials already placed in finished goods inventory.

Accounting for income taxes

We account for income taxes in accordance with the provisions of ASC 740, Income Taxes. The liability method is used to account for deferred income taxes. Under the liability method, deferred tax assets and liabilities are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The ability to realize deferred tax assets is evaluated annually and a valuation allowance is provided if it is unlikely that the deferred tax assets will not give rise to future benefits in our tax returns.

On the basis of this evaluation, as of December 31, 2022, a valuation allowance of $69.7 million has been recorded related to deferred tax assets to recognize only the portion of the deferred tax assets that are more likely than not to be realized. The amount of the deferred tax assets considered realizable, however, could be adjusted if estimates of future taxable income during the carryforward period are reduced or increased or if objective negative evidence in the form of cumulative losses is no longer present and additional weight is given to subjective evidence such as our projections for growth.

We record uncertain tax positions in accordance with ASC 740 on the basis of a two-step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is more than 50% likely to be realized upon ultimate settlement with the related tax authority.

We recognize interest and penalties related to unrecognized tax benefits on the income tax expense line in the accompanying consolidated statement of operations. Accrued interest and penalties are included on the related tax liability line in the consolidated balance sheet.

See additional information regarding income taxes in Note O of our Consolidated Financial Statements.

Recent Accounting Pronouncements

See Note B of our Consolidated Financial Statements for a description of recent accounting pronouncements.

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