# KOPIN CORP (KOPN) FY 2021 MD&A

Verbatim Item 7 Management's Discussion and Analysis from KOPIN CORP's 10-K for fiscal year 2021.

SEC filing source: https://www.sec.gov/Archives/edgar/data/771266/000149315222006784/form10-k.htm
Accession: 0001493152-22-006784
Filing date: 2022-03-14
Report date: 2021-12-25
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/KOPN/
All MD&A years: /company/KOPN/mda/
Next year: /company/KOPN/mda/fy2022/ (FY 2022)

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

Overview

The
following discussion should be read in conjunction with our consolidated financial statements and notes to those statements and other
financial information appearing elsewhere in this Form 10-K. The following discussion contains forward-looking statements. Our actual
results could differ materially from those anticipated in the forward-looking statements as a result of a number of factors, including
the risks discussed in Item 1A “Risk Factors,” and elsewhere in this Form 10-K. Please refer to our cautionary note on Forward-Looking
Statements on page 3 of this Form 10-K.

We
are a leading developer, manufacturer and seller of miniature displays and optical lenses (our “components”) for sale as
individual displays, components, modules or higher-level subassemblies. We also license our intellectual property through technology
license agreements. Our component products are used in highly demanding high-resolution portable defense, enterprise and consumer electronic
applications, training and simulation equipment and 3D metrology equipment. Our products enable our customers to develop and market an
improved generation of products for these target applications.

Critical
Accounting Estimates

Management’s
discussion and analysis of our financial condition and results of operations are based upon our audited consolidated financial statements.
The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets,
liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our
estimates, including those related to revenue recognition under the cost-to-cost measurement method, bad debts, inventories, warranty
reserves, investment valuations, valuation of stock compensation awards, recoverability of deferred tax assets, liabilities for uncertain
tax positions and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be
reasonable under the circumstances, the results of which form the basis for judgments about carrying values of assets and liabilities
that are not apparent from other sources. Actual results may differ from these estimates under different assumptions.

We believe the following critical
accounting policies are most affected by our more significant judgments and estimates used in the preparation of our consolidated financial
statements:

Revenue
Recognition

Substantially
all of our product revenues are derived from the sales of microdisplays, which are sold as individual displays, modules that include
electronics and optics, or higher-level subassemblies for use in defense, industrial and consumer near-eye applications such as avionic
helmets, thermal weapon sights or virtual reality headsets. We also have development contracts for the design, manufacture and modification
of products for the U.S. government or a prime contractor for the U.S. government or for a customer that sells into the industrial or
consumer markets. The Company’s contracts with the U.S. government are typically subject to the Federal Acquisition Regulations
(“FAR”) and are priced based on estimated or actual costs of producing goods. The FAR provides guidance on the types of costs
that are allowable in establishing prices for goods provided under U.S. government contracts. The pricing for non-U.S. government contracts
is based on the specific negotiations with each customer.

Our
fixed-price contracts with the U.S. government or other customers may result in revenue recognized in excess of amounts currently billed.
We disclose the excess of revenues over amounts actually billed as Contract assets and unbilled receivables on the balance sheet. Amounts
billed and due from our customers are classified as Accounts receivable on the balance sheets. In some instances, the U.7S. government
retains a small portion of the contract price until completion of the contract. The portion of the payments retained until final contract
settlement is not considered a significant financing component because the intent is to protect the customer. For contracts with the
U.S. government, we typically receive interim payments either as work progresses or by achieving certain milestones or based on a schedule
in the contract. We recognize a liability for these advance payments in excess of revenue recognized and present it as Contract liabilities
and billings in excess of revenue earned on the balance sheets. The advanced payment typically is not considered a significant financing
component because it is used to meet working capital demands that can be higher in the early stages of a contract and to protect us from
the other party failing to adequately complete some or all of its obligations under the contract. For industrial and consumer purchase
orders, we typically receive payments within 30 to 60 days of shipments of the product, although for some purchase orders, we may require
an advanced payment prior to shipment of the product.

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To
determine the proper revenue recognition method for contracts with the same customer, we evaluate whether two or more contracts should
be combined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than
one performance obligation. For most of our development contracts and contracts with the U.S. government, the customer contracts with
us to provide a significant service of integrating a set of components into a single unit. Hence, the entire contract is accounted for
as one performance obligation. Less frequently, however, we may promise to provide distinct goods or services within a contract in which
case we separate the contract into more than one performance obligation. If a contract is separated into more than one performance obligation,
we allocate the total transaction price to each performance obligation in an amount based on the estimated relative standalone selling
prices of the promised goods or services underlying each performance obligation. In cases where we sell standard products, the observable
standalone sales are used to determine the standalone selling price.

The
Company recognizes revenue from a contract when it has approval and commitment from both parties, the rights of the parties are identified,
payment terms are identified, the contract has commercial substance and collectability of consideration is probable.

For
certain contracts with the U.S. government, the Company recognizes revenue over time as we deliver goods or perform services
because of continuous transfer of control to the customer and the lack of an alternative use for the product. The continuous transfer
of control to the customer is subject to liability clauses in the contract that allow the U.S. government to unilaterally terminate
the contract for convenience, pay us for costs incurred plus a reasonable profit and take control of any work in process. For contracts
with commercial customers, while the contract may have a similar liability clause, our products historically have an alternative use
and thus, revenue is recognized at a point in time.

In
situations where control transfers over time, revenue is recognized based on the extent of progress towards completion of the performance
obligation. We generally use the cost-to-cost approach to measure the extent of progress towards completion of the performance obligation
for our contracts because we believe it best depicts the transfer of assets to the customer. Under the cost-to-cost measure approach,
the extent of progress towards completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion
of the performance obligation. Revenues are recorded proportionally as costs are incurred.

Accounting
for design, development and production contracts requires judgment relative to assessing risks, estimating contract revenues and costs
and making assumptions for schedule and technical issues. Due to the size and nature of the work required to be performed on many of
our contracts, the estimation of total revenue and cost at completion is complicated and subject to many variables. Contract costs include
material, labor and subcontracting costs, as well as an allocation of indirect costs. We have to make assumptions regarding the number
of labor hours required to complete a task, the complexity of the work to be performed, the availability and cost of materials and performance
by our subcontractors. For contract change orders, claims or similar items, we apply judgment in estimating the amounts and assessing
the potential for realization. These amounts are only included in contract value when they can be reliably estimated and realization
is considered probable. If our estimate of total contract costs or our determination of whether the customer agrees that a milestone
achievement is incorrect, our revenue could be overstated or understated and the profits or loss reported could be subject to
adjustment.

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For
our commercial customers, the Company’s revenue is recognized when obligations under the terms of a contract with our customer
are satisfied and the Company transfers control of the products or performs services, which is generally upon delivery of the
product to the customer or performance of the services. Revenue is recorded as the amount of consideration we expect to receive
in exchange for transferring goods or providing services. Provisions for product returns and allowances are reductions in the transaction
price and are recorded in the same period as the related revenues. We analyze historical returns, current economic trends and changes
in customer demand when evaluating the adequacy of sales returns and other allowances. Certain product sales are made to distributors
under agreements allowing for a limited right of return on unsold products. Sales to distributors are primarily made for sales to the
distributors’ customers and not for stocking of inventory. Sales, value add and other taxes we collect concurrent with revenue-producing
activities are excluded from revenue.

The
Company also licenses its intellectual property (“IP”) through technology license agreements which provides the customer
the right to use our IP as it exists at a point in time. These agreements may include other performance obligations including the sale
of product to the customer. The satisfaction of the Company’s performance obligation, and related recognition of revenue, occurs
when the IP is delivered to the customer, the license period has begun and there are no additional performance obligations in the agreement.
When the license is distinct from other obligations in the agreement, the Company treats the license and other performance obligations
as separate performance obligations. Accordingly, the license is recognized at a point in time or over time based on the standalone selling
price. Under certain license agreements, we may receive royalties based on the sales of the licensed product. We recognize royalty revenue
upon the later of when the related sales occur, or when the performance obligation to which some or all of the royalty has been allocated
has been satisfied (or partially satisfied). Under our current license agreements for which a royalty exists, we have recorded revenue
when the related sales by our customer occurs because the performance obligation related to the delivery of the license to the customer
has been satisfied.

Inventory

We
provide a reserve for estimated obsolete or unmarketable inventory based on assumptions about future demand and market conditions and
our production plans. Inventories that are obsolete or slow moving are generally fully reserved (representing the estimated net realizable
value) as such information becomes available. Our display products are manufactured based upon production plans whose critical assumptions
include non-binding demand forecasts provided by our customers, lead times for raw materials, lead times for wafer foundries to perform
circuit processing and yields. If a customer were to cancel an order or actual demand was lower than forecasted demand, we may not be
able to sell the excess display inventory and additional reserves would be required. If we were unable to sell the excess inventory,
we would establish reserves to reduce the inventory to its estimated realizable value (generally zero).

Investment
Valuation

We
periodically make equity investments in private companies, accounted for as an equity investment, whose values are difficult to determine.
The Company adopted ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets
and Liabilities and the related amendments on December 31, 2017. The Company adopted the measurement alternative for equity investments
without readily determinable fair values (often referred to as cost method investments) on a prospective basis. When assessing investments
in private companies for impairment, we consider such factors as, among others, the share price from the investee’s latest financing
round, the performance of the investee in relation to its own operating targets and its business plan, the investee’s revenue and
cost trends, the liquidity and cash position, including its cash burn rate and market acceptance of the investee’s products and
services. Because these are private companies which we do not control we may not be able to obtain all of the information we would want
in order to make a complete assessment of the investment on a timely basis. Accordingly, our estimates may be revised if other information
becomes available at a later date.

In
addition to the above, we make investments in government and agency-backed securities and corporate debt securities. For all of our investments
we provide for an impairment valuation if we believe a decline in the value of an investment is other-than-temporary, which may have
an adverse impact on our results of operations. The determination of whether a decline in value is other-than-temporary requires that
we estimate the cash flows we expect to receive from the security. We use publicly available information such as credit ratings and financial
information of the entity that issued the security in the development of our expectation of the cash flows to be received. Historically,
we have periodically recorded other-than-temporary impairment losses, however we have not done so recently.

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Income
Taxes

We
have historically incurred domestic operating losses from both a financial reporting and tax return standpoint. We establish valuation
allowances to the extent it appears more likely than not that our deferred tax assets will not be realized. These judgments are
based on our projections of taxable income and the amount and timing of our tax operating loss carryforwards and other deferred tax assets.
Given our federal operating tax loss carryforwards, we do not expect to pay domestic federal taxes in the near term. It is possible that
we could pay foreign and state income taxes. We are also subject to foreign taxes from our Korean and U.K. subsidiary operations.

Our
income tax provision is based on calculations and assumptions that will be subject to examination by tax authorities. Despite our history
of operating losses there can be exposures for state taxes or foreign tax that may be due. We regularly assess the potential outcomes
of these examinations and any future examinations for the current or prior years in determining the adequacy of our provision for income
taxes. Should the actual results differ from our estimates, we would have to adjust the income tax provision in the period in which the
facts that give rise to the revision become known. Such adjustment could have a material impact on our results of operations. We have
historically established valuation allowances against all of our net deferred tax assets because of our history of generating operating
losses and restrictions on the use of certain items. Our evaluation of the recoverability of deferred tax assets has also included analysis
of the expiration dates of net operating loss carryforwards. In forming our conclusions as to whether the deferred tax assets are more
likely than not to be realized we consider the sources of our income and the projected stability of those sources and product life cycles.

Results
of Operations

We
have two principal sources of revenues: product revenues and research and development (“R&D”) revenues. R&D revenues
consist primarily of development contracts with agencies or prime contractors of the U.S. government and commercial enterprises.

We
manufacture transmissive and reflective microdisplays. Our commercial and defense transmissive display production is being performed
entirely in our Westborough, Massachusetts facility. FDD, our wholly-owned subsidiary, manufactures our reflective microdisplays in its
facility located in Scotland. Our OLED displays are designed by us and manufactured by third parties for us.

We
are a display supplier for the U.S. Army’s Family of Weapon Sights Individual and Joint Strike Fighter F-35 programs
and are undergoing qualification for the FWS - Crew Served variant. We are also in development for a new series of displays for armored
vehicles under the M1A2 program. The FWS, M1A2 and our existing production avionic programs are expected to increase production for the
next several years. There are other firms offering products which compete against us in the defense programs and all of the programs
we supply product to are subject to the U.S. government defense budget and procurement process. Accordingly, there can be no assurances
we will continue to ship under our defense contracts.

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We
offer microdisplays and optical lenses for use in consumer, enterprise and public safety products and systems which are targeted at AR
and VR markets, among other areas. We refer to the sale of microdisplays and optical lenses as our component sales. We also offer head
mounted, voice and gesture controlled, hands-free headset system designs that include our components and software for consumer and enterprise
applications.

Predicting
our R&D revenue and related trends is challenging because we have limited ability to forecast if we will be awarded additional R&D
contracts in the future as such awards depend on the U.S. military budget and priorities. We cannot assure that the R&D contracts
will result in workable products or if successful our products developed under these contracts will be procured by our customers. If
we do not continue to win R&D contracts or if there is no demand for the products developed under these contracts, our ability to
achieve profitability and positive cash flow could be negatively affected because the R&D revenues (or the products derived from
the R&D contracts) would not be available to cover the allocated overhead and selling, general and administrative costs which may
remain. Some of our contracts are fixed priced and we may incur cost overruns that would result in losses on the contracts.
If we incur such losses on our contracts our ability to achieve profitability and positive cash flow could be negatively affected.

Because
our fiscal year ends on the last Saturday of December, every seven years we have a fiscal year with 53 weeks. Our fiscal years
2021, 2020 and 2019 were each 52 week years.

Revenues.
Our revenues by display application, which include product sales and amounts earned from research and development contracts, for
fiscal years 2021, 2020 and 2019 by category, were as follows:

[[GREPCENT_TABLE]]
[["(In thousands)","","2021","","","2020","","","2019"],["Defense","","$","18,180","","","$","20,231","","","$","8,729"],["Industrial/Enterprise","","","9,710","","","","6,882","","","","9,717"],["Consumer","","","1,871","","","","852","","","","1,777"],["Research and Development","","","14,669","","","","10,123","","","","4,983"],["Other","","","121","","","","553","","","","61"],["License and royalties","","","1,115","","","","1,487","","","","4,252"],["Total Revenues","","$","45,666","","","$","40,128","","","$","29,519"]]
[[/GREPCENT_TABLE]]

Fiscal
Year 2021 Compared to Fiscal Year 2020

Sales
of our products for Defense applications include systems used by the military both in the field and for training and simulation. Sales
of our products for Defense applications may be for a one-time purchase order or for programs that run for several years. Revenues
from product sales to defense customers decreased in 2021 compared to 2020, primarily due to a decrease in shipments of our
products into the Joint Strike Fighter program and training and simulation programs.

Industrial/Enterprise
applications revenues represent customers who purchase our display products for use in headsets used for manufacturing, distribution,
public safety, 3D metrology equipment and other industrial applications. Our 3D metrology customers are primarily located in Asia and
they sell to Asian contract manufacturers who use the 3D metrology machines for quality control purposes. The increase in Industrial/Enterprise
applications revenues in 2021 compared to 2020 was primarily due to an increase in sales to customers who use our display components
in 3D metrology equipment and industrial headsets.

Sales
of our displays for Consumer applications is primarily for the use in thermal imaging products, recreational rifle and hand-held scopes.
The increase in Consumer applications in 2021 compared to 2020 was primarily due to increased demand for our organic light emitting displays
(“OLEDS”).

R&D
revenues increased in 2021 as compared to 2020 primarily due to additional funding for new display technology development which we believe
will be used in U.S. defense programs. These contracts typically reimburse us for direct costs and allocated overhead and selling, general
and administrative costs and in some cases profit. In 2021 and 2020 our R&D revenues exceeded funded R&D expenses by approximately
$4.7 million and $2.4 million, respectively.

The
decrease in license and royalty revenue in 2021 compared to 2020 is due to lower royalties earned under IP license agreements for industrial
wearable headsets.

International
product sales represented approximately 38% and 20% of product revenues for 2021 and 2020, respectively. Our international
sales increased in 2021 as compared to 2020 due to an increase in sales of our products for 3D metrology application by our subsidiary,
Forth Dimension Display, located in Scotland. Our international sales are primarily denominated in U.S. dollars. Consequently, a strengthening
of the U.S. dollar could increase the price in local currencies of our products in foreign markets and make our products relatively more
expensive than competitors’ products that are denominated in local currencies, which could result in a reduction in sales or profitability
in those foreign markets. As a result, our financial position and results of operations are subject to exchange rate fluctuation in transactional
and functional currency. We have not taken any protective measures against exchange rate fluctuations, such as purchasing hedging instruments
with respect to such fluctuations, because of the historically stable exchange rate between the Japanese yen, Great Britain pound and
the U.S. dollar. Foreign currency translation impact on our results, if material, is described in further detail under “Item 7A.