DIODES INC /DEL/ (DIOD) FY 2022 MD&A

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

The following section discusses management’s view of the financial condition, results of operations and cash flows of Diodes Incorporated and its subsidiaries (collectively, “the Company,” “our Company,” “we,” “our,” “ours,” or “us”) and should be read together with the consolidated financial statements and the notes to consolidated financial statements included elsewhere in this Form 10-K.

The following discussion contains forward-looking statements and information relating to our Company. We generally identify forward-looking statements by the use of terminology such as “may,” “will,” “could,” “should,” “potential,” “continue,” “expect,” “intend,” “plan,” “estimate,” “anticipate,” “believe,” “project,” or similar phrases or the negatives of such terms. We base these statements on our beliefs as well as assumptions we made using information currently available to us. Such statements are subject to risks, uncertainties and assumptions, including those identified in Part I, Item 1A.“Risk Factors,” as well as other matters not yet known to us or not currently considered material by us. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated or projected. Given these risks and uncertainties, prospective investors are cautioned not to place undue reliance on such forward-looking statements. Forward-looking statements do not guarantee future performance and should not be considered as statements of fact.

You should not unduly rely on these forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. Unless required by law, we undertake no obligation to publicly update or revise any forward-looking statements to reflect new information or future events or otherwise. The Private Securities Litigation Reform Act of 1995 (the “Act”) provides certain “safe harbor” provisions for forward-looking statements. All forward-looking statements made in this Annual Report on Form 10-K are made pursuant to the Act.

General

Diodes Incorporated, together with its subsidiaries (collectively the “Company,” “we” or “our” (Nasdaq: DIOD)), a Standard and Poor's Smallcap 600 and Russell 3000 Index company, is a leading global manufacturer and supplier of high-quality application-specific standard products within the broad discrete, logic, analog, and mixed-signal semiconductor markets. The Company serves the industrial, automotive, computing, communications and consumer markets.

The Company's products include diodes; rectifiers; transistors; MOSFETs; GPP bridges; GPP rectifiers; protection devices; function-specific arrays; single gate logic; amplifiers and comparators; Hall-effect and temperature sensors; and power management devices, including LED drivers, AC-DC converters and controllers, DC-DC switching and linear voltage regulators, voltage references along with special-function devices, such as USB power switches, load switches, voltage supervisors, and motor controllers. The Company also has timing, connectivity, switching, and signal integrity solutions for high-speed signals.

The Company's corporate headquarters and Americas’ sales offices are located in Plano, Texas, and Milpitas, California, respectively. Design, marketing, and engineering centers are located in Plano; Milpitas; Taipei, Taoyuan City, and Zhubei City, Taiwan; Shanghai and Yangzhou, China; Oldham, England; and Neuhaus, Germany. The Company's wafer fabrication facilities are located in Oldham, England; Greenock, Scotland; Shanghai and Wuxi, China; and Keelung, and Hsinchu, Taiwan and South Portland, Maine, United States. The Company has assembly and test facilities located in Shanghai, Jinan, Chengdu, and Wuxi, China; Neuhaus, Germany; and Jhongli and Keelung, Taiwan. Additional engineering, sales, warehouse, and logistics offices are located in Taipei, Taiwan; Hong Kong; Oldham, England; Shanghai, Shenzhen, Wuhan, and Yangzhou, China; Seongnam-si, South Korea; and Munich and Frankfurt, Germany; with support offices throughout the world.

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The Company’s manufacturing facilities have achieved certifications in the internationally recognized standards of ISO 9001:2015, ISO 14001:2015, and, for automotive products, IATF 16949:2016;

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Diodes Incorporated is also C-TPAT certified; and

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We believe these quality awards reflect the superior quality-control techniques established at Diodes Incorporated and further enhance our credibility as a vendor-of-choice to original equipment manufacturers ("OEMs") increasingly concerned with quality and consistency.

Our market focus is on high-growth, end-user applications in the following areas:

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Industrial: embedded systems, precision controls, and Industrial IoT;

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Automotive: connected driving, comfort/style/safety, and electrification/powertrain;

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Computing: cloud computing including server, storage, and data center applications;

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Communications: smartphones, 5G networks, advanced protocols, and charging solutions; and

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Consumer: IoT, wearables, home automation, and smart infrastructure;

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This discussion summarizes the significant factors affecting the consolidated operating results, financial condition and liquidity of the Company for the twelve months ended December 31 2022. This discussion should be read in conjunction with Item 8, the consolidated financial statements and the notes to consolidated financial statements.

Summary for the Twelve Months Ended December 31, 2022

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Net sales were $2.0 billion, an increase of 10.8% over the $1.81 billion in 2021;

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Gross profit was $827.2 million, a 23.4% increase from $670.4 million in 2021;

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Gross profit margin improved 420 basis points to a record 41.3% from 37.1% in 2021;

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Operating income increased 47.9% to a record $408.2 million, or 20.4% of revenue, compared to $276.0 million, or 15.3% of revenue, in 2021;

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Net income was a record $331.3 million, an increase of 44.8% from the $228.8 million last year;

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Earnings per share was $7.20 per diluted share, a 44.0% improvement from the $5.00 per diluted share in 2021;

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We achieved $392.5 million cash flow from operations. We had cash capital expenditures of $211.7 million, or 10.6% of net sales. Net cash flow was a negative $25.7 million, which includes the net pay-down of $133.0 million of long-term debt.

Summary for the Twelve Months Ended December 31, 2021

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Net sales were $1.81 billion, an increase of 46.9% from the $1.23 billion in 2020;

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Gross profit was $670.4 million, a 55.5% increase, compared to the $431.1 million in 2020;

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Gross margin improved 200 basis points to 37.1% from 35.1% in 2020;

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Operating income increased 105.4% to $276.0 million, or 15.3% of net sales, compared to $134.3 million, or 10.9% of net sales, in 2020;

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Net income was $228.8 million, or $5.00 per diluted share, compared to $98.1 million, or $1.88 per diluted share, in 2020; and

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We achieved $338.5 million cash flow from operations. We had cash capital expenditures of $141.2 million, or 7.8% of net sales. Net cash flow was a positive $46.3 million.

Business Outlook and Factors Relevant to Our Results of Operations

Our record financial performance in 2022 represents a significant step toward our 2025 business targets of $1.0 billion of gross profit, based upon net sales of $2.5 billion and gross margin of 40%. Acquisitions will continue to be part of our growth strategy to reach our 2025 revenue and gross profit goal. We have a solid pipeline of designs and expanded customer relationships across all regions and product lines. The success of our business depends on, among other factors, the strength of the global economy and the stability of the financial markets, our customers’ demand for our products, the ability of our customers to meet their payment obligations, customers not canceling or deferring existing orders, and the strength of consumers’ demand for items containing our products in the end-markets we serve. We believe the long-term outlook for our business remains generally favorable despite the uncertainties in the global economy as we continue to execute on the strategy that has proven successful for us over the years. See “Risk Factors – The success of our business depends on the strength of the global economy and the stability of the financial markets, and any weaknesses in these areas may have a material adverse effect on our net sales, operating results and financial condition.” in Part I, Item 1A of this Annual Report for additional information.

Description of Sales and Expenses

Net sales

The principal factors that have affected or could affect our net sales from period to period are:

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The condition of the economy in general and of the semiconductor industry in particular;

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Additional COVID outbreaks with increasing infection rates and lockdowns by local governments could have a negative impact on our production facilities;

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The February 2022 invasion of Ukraine by Russia and the resulting and continuing global impact;

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Political tension, including the implementation of tariffs, among and between the countries in which we do business;

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Our customers’ adjustments in their order levels;

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Changes in our pricing policies or the pricing policies of our competitors or suppliers;

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The addition or termination of key supplier relationships;

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The rate of introduction and acceptance by our customers of new products;

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Our ability to compete effectively with our current and future competitors;

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Our ability to enter into and renew key corporate and strategic relationships with our customers, vendors and strategic alliances;

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Changes in foreign currency exchange rates;

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A major disruption of our information technology infrastructure;

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Unforeseen catastrophic events, such as armed conflict, terrorism, fires, typhoons and earthquakes;

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Any other disruptions, such as change in the political or governmental policies, labor shortages, unplanned maintenance or other manufacturing problems; and

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Other risks, uncertainties, and assumptions identified in item 1A, "Risk Factors," of this Annual Report on Form 10-K and risks, uncertainties, and assumptions reflected in other documents we file with the SEC.

Cost of goods sold

Cost of goods sold includes manufacturing costs for our semiconductors and our wafers. These costs include raw materials used in our manufacturing processes as well as labor costs and overhead expenses. Cost of goods sold is also impacted by yield improvements, capacity utilization and manufacturing efficiencies. In addition, cost of goods sold includes the cost of products that we purchase from other manufacturers and sell to our customers. Cost of goods sold is also affected by inventory obsolescence if our inventory management is not efficient.

Selling, general and administrative

Selling, general and administrative expenses relate primarily to compensation and associated expenses for personnel in general management, sales and marketing, information technology, engineering, human resources, procurement, planning and finance, and sales commissions, as well as outside legal, investor relations, accounting, consulting and other operating expenses. Also included in selling, general and administrative expenses are acquisition costs from business combinations.

Research and development

Research and development expenses consist of compensation and associated costs of employees engaged in research and development projects, as well as materials and equipment used for new product development and technology qualification. Research and development expenses are executed on a global basis and are primarily associated with where the engineering talent is located, as well as the location of manufacturing sites participating in any required technology or process development. All research and development expenses are expensed as incurred.

Amortization of acquisition-related intangible assets

Amortization of acquisition-related intangible assets consists of assets such as developed technologies and customer relationships.

Interest income / expense

Interest income consists of interest earned on our cash and investment balances. Interest expense consists of interest payable on our outstanding credit facilities and other debt instruments.

Foreign currency (loss) gain, net

This income account is used to show the amount gained or lost as a result of foreign currency transactions.

Unrealized (loss) gain on investments

We hold investments in the form of common stock or some other similar equivalent accounted for under fair-value accounting. This account is used to show the necessary mark-to-market adjustments.

Income tax provision

Our global presence requires us to pay income taxes in a number of jurisdictions. See Note 12 of “Notes to Consolidated Financial Statements” for additional information.

Net income attributable to noncontrolling interest

This represents the minority investors’ share of our subsidiaries’ earnings.

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Net income attributable to common stockholders

Net income attributable to common stockholders is net income less net income attributable to noncontrolling interest.

Results of Operations

The following table sets forth, for the periods indicated, the percentage that certain items in the statements of income bear to net sales:

The following discussion explains in greater detail our consolidated operating results and financial condition. This discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K (in thousands).

Net Sales

Our net sales increased approximately $195.4 million, or 10.8%, for the twelve months ended December 31, 2022, compared to the prior year, due primarily to our content expansion initiatives and improvements in product mix. The Company has experienced growth in higher-margin end markets which have enabled the Company to increase its net sales and margins, even in the midst of the current supply-constrained environment. For the twelve months ended December 31, 2022, weighted-average sales price of the Company's products increased 28.5% when compared to the prior year. This represents the improved product mix across the portfolio, as well as price increases to offset supply chain cost increasing.

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The table below sets forth our revenue as a percentage of product revenue by end-user market:

Cost of Goods Sold

Cost of goods sold increased approximately $38.5 million for the twelve months ended December 31, 2022 compared to the same period last year. As a percent of sales, cost of goods sold was 58.7% for the twelve months ended December 31, 2022, compared to 62.9% for the same period last year. Average unit cost increased 19.9% for the twelve months ended December 31, 2022, compared to the same period last year, due to cost increases from various subcontractors and foundries, as well as the cost for a more premium mix of products that were sold in 2022. For the twelve months ended December 31, 2022, gross profit increased approximately 23.4% when compared to the prior year. Gross profit margin for the twelve month periods ended December 31, 2022 and 2021, was 41.3% and 37.1%, respectively.

Operating expenses

Operating expenses for the twelve months ended December 31, 2022 increased approximately $24.7 million, or 6.3%, compared to the same period last year. Selling, general and administrative expenses (“SG&A”) increased approximately $23.2 million. The increase in SG&A was driven by increases in wages and benefits, selling expenses and freight and duty charges. Research and development expenses (“R&D”) increased approximately $7.1 million primarily due to increases in wages and benefits, and costs associated with new product and new process development activities. Amortization of acquisition-related intangibles decreased approximately 4.0% reflecting the overall reduction in the balance of intangible assets subject to amortization. SG&A, as a percentage of sales, was 14.0% and 14.3% for the twelve-month periods ended December 31, 2022 and 2021, respectively. R&D, as a percentage of sales, was 6.3% and 6.6% for the twelve-month periods ended December 31, 2022 and 2021, respectively.

Other (expense)/income

Interest income was relatively flat when compared to 2021. The increase in interest expense is due to increased interest rates on our floating rate debt partially offset by lower borrowing levels. Foreign currency gain increased $4.2 million during the twelve months ended December 31, 2022 due to the effectiveness of the Company's hedging program. Unrealized loss on investments increased from 2021 due to investment losses from investments the Company acquired in the LSC acquisition.

Income tax provision

We recognized income tax expense of approximately $56.7 million for the twelve months ended December 31, 2022, and income tax expense of approximately $78.8 million for the twelve months ended December 31, 2021, resulting in effective income tax rates of 14.3% and 25.0%, respectively. The decrease in the effective tax rate for 2022 compared to 2021 is primarily attributable to an increase in overall pre-tax book income and the impact of changes to the outside basis difference in foreign subsidiaries where the Company does not assert permanent reinvestment. Our undistributed foreign earnings continue to be indefinitely reinvested in foreign operations, with limited exceptions related to earnings of European and Asian subsidiaries. Any future distributions of foreign earnings will not be subject to additional U.S. income tax but may be subject to foreign withholding taxes. The Company has recorded outside basis differences in the limited instances where they do not assert permanent reinvestment. As of December 31, 2022, our foreign subsidiaries held approximately $296.8 million of cash, cash equivalents and investments of which approximately $68.0 million would be subject to foreign withholding tax if distributed outside the country in which the related earnings were generated.

Financial Condition

Liquidity and Capital Resources

Our primary sources of liquidity are cash and cash equivalents, short-term investments, funds from operations and, if necessary, borrowings under our credit facilities.

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Liquidity requirements

Our primary liquidity requirements have been to meet our capital expenditure needs and to fund ongoing operations. For 2022 and 2021 our working capital was $729.1 million and $716.6 million, respectively. In 2022, our working capital increased primarily due to increases in accounts receivable and inventories, and decrease in our accounts payable and the current portion of long-term debt. We expect cash generated by our operations together with existing cash, cash equivalents, short-term investments and available credit facilities to be sufficient to satisfy our working capital needs, capital asset purchases, outstanding commitments and other liquidity requirements associated with our existing operations for at least the next 12 months.

Short-term investments

As of December 31, 2022, we had short-term investments of approximately $7.1 million. These investments are highly liquid with maturity dates greater than three months at the date of purchase. We generally can access these investments in a relatively short amount of time but in doing so we generally forfeit a portion of interest income.

Short-term debt

Our Asia subsidiaries maintain credit facilities with several financial institutions through our foreign entities worldwide totaling $172.8 million. Other than two Taiwanese credit facilities that are collateralized by assets, our foreign credit lines are unsecured, uncommitted and contain no restrictive covenants. These credit facilities bear interest at LIBOR or similar indices plus a specified margin. Interest payments are due monthly on outstanding amounts under the credit lines. The unused and available credit under the various facilities as of December 31, 2022, was approximately $136.0 million, net of $36.3 million advanced under our foreign credit lines and $0.4 million credit used for import and export guarantee.

Long-term debt

The Company maintains a long-term credit facility (“U.S. Credit Agreement”) consisting of a term loan with a current balance of zero and a $200.0 million revolving senior credit facility with zero drawn as of December 31, 2022. The revolving senior credit facility and term loan mature on May 29, 2024. Both the term loan portion and the revolving portion of the Credit Agreement bear an interest rate at LIBOR or similar other indices plus a specified margin. The Credit Agreement contains certain financial and non-financial covenants, including, but not limited to, a maximum Consolidated Leverage Ratio, a minimum Consolidated Fixed Charge Coverage Ratio, and restrictions on liens, indebtedness, investments, fundamental changes, dispositions, and restricted payments (including dividends and share repurchases). Furthermore, under the Credit Agreement, restricted payments, including dividends and share repurchases, are permitted in certain circumstances, including while the pro forma Consolidated Leverage Ratio is, both before and after giving effect to any such restricted payment, at least 0.25 to 1.00 less than the maximum permitted under the Credit Agreement. In addition to the liquidity provided by the U.S. Credit Agreement, our 51% owned subsidiary, Eris Technology Company ("ERIS"), borrowed $25.8 million on a long-term basis from local Taiwan banks. The ERIS debt matures in periods through 2033.

Diodes Hong Kong Limited, a company incorporated under the laws of Hong Kong and a subsidiary of the Company, has a US Dollar revolving loan facility in an aggregate amount equal to $105.0 million (the "Facility"). Diodes Hong Kong Limited used a portion of the proceeds for the Facility (i) to refinance certain existing indebtedness and (ii) to finance working capital requirements and its general corporate purposes. In addition, on January 22, 2021, Diodes Hong Kong Limited entered into a Hong Kong Debenture (the “Debenture”) with The Hongkong and Shanghai Banking Corporation Limited, as Security Agent (the “Security Agent”). Pursuant to the Debenture, Diodes Hong Kong Limited granted to the Security Agent, on behalf of itself and the other secured parties, a security interest over certain assets of Diodes Hong Kong Limited. The security interest is continuing security for the payment, discharge and performance of all of the secured liabilities, which includes Diodes Hong Kong Limited’s payment obligations under the Facility. The Facility is governed by the laws of Hong Kong.

Capital expenditures and investments

In 2022 and 2021, our total cash capital expenditures were approximately $211.7 million and $141.2 million, respectively. Our capital expenditures for these periods were primarily related to manufacturing expansion in both our assembly/test and wafer fabrication facilities. Cash capital expenditures in 2022 were approximately 10.6% of our net sales. The Company's 2022 capital expenditures were higher than our target model of 5% to 9% of net sales, due to expansion of our wafer fabrication facility in Hsinchu Science Park in Taiwan. Going forward, over the long term, the Company expects capital expenditures to be within the 5% to 9% of net sales target model range.

The Company’s restricted cash primarily consisted of the cash required to be on deposit under contractual agreements with banks to support outstanding loan and import/export guarantees. As of December 31, 2022, restricted cash of $4.4 million was pledged as collateral for issuance of bank loans, bank acceptance notes and letters of credit.

Our foreign operations expose us to unique intellectual property technology and other risks compared to a company with fewer or no international operations. For example, we are exposed to potential cyber security breaches that may target our employees or infrastructure outside the United States. These risks may result in material and adverse impacts on our financial condition and results of operations. See “Risk Factors – Risks Related to Our International Operations” in Part I, Item 1A of this Annual Report for a more detailed summary of the intellectual property technology risks and other associated with our international business operations.

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Discussion of Cash Flows

Cash and cash equivalents, including restricted cash, decreased approximately $25.7 million to $341.1 million in 2022 from $366.8 million in 2021. The table below sets forth summary information from our statements of cash flows:

Operating Activities

Net cash provided by operating activities for 2022 was approximately $392.5 million, due primarily to $339.3 million of net income, $127.8 million in depreciation expense and amortization of intangible assets expense and $36.3 million from non-cash share-based compensation expense and a non-cash loss on investments of $16.2 million. These increases were partially offset by a net decrease in operating capital assets and liabilities of $81.1 million, a decrease in deferred income taxes of $39.2 million.

Investing Activities

Net cash used in investing activities for 2022 was approximately $265.3 million, due primarily to the purchase of property, plant and equipment for $211.7 million and the purchase of SPFAB for $80.4 million.

Financing Activities

Net cash used in financing activities for 2022 was approximately $125.7 million, due primarily to the net reduction in our outstanding indebtedness of $112.2 million and taxes on net share settlements of $12.3 million.

Debt instruments

The U.S. credit facility contains certain financial and non-financial covenants, including, but not limited to, a maximum consolidated leverage ratio, a minimum consolidated fixed charge coverage ratio, and restrictions on liens, indebtedness, investments, fundamental changes, dispositions, and restricted payments (including dividends and share repurchases).

As of December 31, 2022, our Asia subsidiaries had unused and available credit lines of up to an aggregate of approximately $136.0 million, with several financial institutions. Our foreign credit lines are unsecured and uncommitted, except for two Taiwanese credit facilities that are collateralized by assets. Our foreign credit lines bear interest at LIBOR or similar indices plus a specified margin. At December 31, 2022, $36.3 million was outstanding under these lines of credit. In addition to our credit lines, our 51% owned subsidiary, ERIS Technology Corporation (“ERIS”), had long-term debt of $25.8 million, at December 31, 2022, from local Taiwan banks. The outstanding ERIS debt matures in various periods from 2024 through 2033. See “Liquidity and Capital Resources” above and Note 8 of “Notes to Consolidated Financial Statements” of this Annual Report for additional information.

Diodes Hong Kong Limited, a company incorporated under the laws of Hong Kong and a subsidiary of the Company, has a US Dollar revolving loan facility in an aggregate amount equal to $105.0 million (the "Facility"). Diodes Hong Kong Limited used a portion of the proceeds of the Facility (i) to refinance certain existing indebtedness and (ii) to finance working capital requirements and its general corporate purposes. In addition, on January 22, 2021, Diodes Hong Kong Limited entered into a Hong Kong Debenture (the “Debenture”) with The Hongkong and Shanghai Banking Corporation Limited, as Security Agent (the “Security Agent”). Pursuant to the Debenture, Diodes Hong Kong Limited granted to the Security Agent, on behalf of itself and the other secured parties, a security interest over certain assets of Diodes Hong Kong Limited. The security interest is continuing security for the payment, discharge and performance of all of the secured liabilities, which includes Diodes Hong Kong Limited’s payment obligations under the Facility. The Facility is governed by the laws of Hong Kong.

Contractual Obligations

Our estimated future obligations consist of debt, interest on long-term debt, leases, defined benefit obligation and purchase obligations. See Note 8 “Bank Credit Agreements and Other Short-term and Long-term Debt, Note 9 - "Leases", Note 13 - "Employee Benefit Plans" and Note 17 - "Commitments and Contingencies” of the notes to consolidated financial statements" included elsewhere in this Annual Report for additional information.

We cannot make reasonable estimates of the amount and period in which our tax liabilities will be paid. See “Accounting for income taxes” below and Note 12 of “Notes to Consolidated Financial Statements” of this Annual Report for additional information.

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Critical Accounting Estimates

The preparation of financial statements in conformity with generally accepted principles in the United States of America (“U.S. GAAP”) requires that management 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 net sales and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, which are based upon historical experiences, market trends and financial forecasts and projections, and upon various assumptions that management believes to be reasonable under the circumstances at that certain point in time. Actual results may differ, significantly at times, from these estimates under different assumptions or conditions.

We believe the following critical accounting estimates affect the significant estimates and judgments we use in the preparation of our consolidated financial statements, and may involve a higher degree of judgment and complexity than others.

Revenue recognition

In relation to our revenue recognition, we record estimated allowances/reserves for the following items;

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Ship and debit reserves, which arise when we, from time to time based on market conditions, issue credit to certain distributors upon their shipments to their end customers;

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Stock rotation reserves, which are contractual obligations that permit certain distributors, up to four times a year, to return a portion of their inventory based on historical shipments to them in exchange for an equal and offsetting order;

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Price protection reserves, which arise when market conditions cause average selling prices to decrease and we issue credit to certain distributors on their inventory;

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Accounts receivable reserves related to our customer's ability to pay; and

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Product returns, distributor price adjustments and other allowances.

Our reserve estimates are based upon historical data as well as projections of sales, distributor inventories, price adjustments, average selling prices and market conditions. Actual returns and adjustments could be significantly different from our estimates and provisions, resulting in an adjustment to net sales.

Inventories

Inventories are stated at the lower of cost or net realizable value. Cost is determined principally by the first-in, first-out method. On an ongoing basis, we evaluate our inventory for obsolescence and slow-moving items. This evaluation includes analysis of sales levels, sales projections, and purchases by item, as well as raw material usage related to our manufacturing facilities. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis. If future demand or market conditions are different than our current estimates, an inventory adjustment may be required, and would be reflected in cost of goods sold in the period the revision is made.

Accounting for income taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the tax jurisdictions in which we operate. This process involves using an asset and liability approach whereby deferred tax assets and liabilities are recorded for differences in the financial reporting bases and tax bases of our assets and liabilities. A valuation allowance is provided against deferred tax assets unless it is more likely than not that such deferred tax assets will be realized. This analysis requires considerable judgment and is subject to change to reflect future events and changes in the tax laws.

The benefit of a tax position is recognized only if it is more likely than not that the tax position would be sustained based on its technical merits in a tax examination, using the presumption the tax authority has full knowledge of all relevant facts regarding the position. The amount of benefit recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on ultimate settlement with the tax authority. For tax positions not meeting the more likely than not test, no tax benefit is recorded.

Goodwill and other indefinite lived intangible assets

Goodwill and other indefinite lived assets are tested for impairment on an annual basis or when an event or changes in circumstances indicate that its carrying value may not be recoverable. Goodwill impairment is tested at the reporting unit level, which is defined as an operating segment or one level below the operating segment. We have one operating segment. Goodwill is reviewed for impairment using either a qualitative assessment or a quantitative goodwill impairment test. If we choose to perform a qualitative assessment and determine the fair value more likely than not exceeds the carrying value, no further evaluation is necessary. When we perform the quantitative goodwill impairment test, we compare fair value to carrying value, which includes goodwill. If fair value of exceeds carrying value, the goodwill is not considered impaired. If the carrying value is higher than the fair value, the difference would be recognized as an impairment loss. We determine the fair value of our reporting units based on an income approach, whereby the fair value of the reporting unit is derived from the present value of estimated future cash flows. The assumptions about estimated cash flows

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include factors such as future revenue, gross profit, operating expenses, and industry trends. We consider historical rates and current market conditions when determining the discount and long-term growth rates to use in its analysis. We consider other valuation methods, such as the cost approach or market approach, if it is determined that these methods provide a more representative approximation of fair value.

Business Combinations

Significant judgment is often required in estimating the fair value of assets acquired and liabilities assumed. The Company makes estimates and assumptions about conditions of the assets, other costs not captured in the base costs, and consideration for entrepreneurial profit, depreciation, functional obsolescence, and economic obsolescence allocated to the various property, plant and equipment categories considering the perspective of marketplace participants.

Recently Issued Accounting Pronouncements

See Note 1 of “Notes to Consolidated Financial Statements” of this Annual Report for additional information regarding the status of recently issued accounting pronouncements.

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