MASIMO CORP (MASI) FY 2022 MD&A

ITEM 7.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read this discussion together with the financial statements, related notes and other financial information included in this Annual Report on Form 10-K. The following discussion may contain predictions, estimates and other forward-looking statements that involve a number of risks and uncertainties, including those discussed under Item 1A—“Risk Factors” and elsewhere in this Annual Report on Form 10-K. These risks could cause our actual results to differ materially from any future performance suggested below.

Executive Overview

We are a global technology company dedicated to improving lives. In connection with the acquisition of Viper Holdings Corporation d/b/a Sound United, LLC (Sound United), we announced an organizational structure change designed to accelerate our growth strategies and strengthen our focus on patient care, thereby creating two reportable segments: healthcare and non-healthcare.

We commenced reporting under this new structure effective for the quarter ended July 2, 2022. The new non-healthcare segment was created as a result of the Sound United Acquisition. Please see Note 18 “Business Combinations”, accompanying consolidated financial statements included in Part IV, Item 15(a) of this Annual Report on Form 10-K.

Healthcare

Our healthcare business develops, manufactures and markets a variety of noninvasive patient monitoring technologies, hospital automation and connectivity solutions, remote monitoring devices and consumer health products. Our patient monitoring solutions generally incorporate a monitor or circuit board, proprietary single-patient use or reusable sensors, software, cables and other services. We primarily sell our healthcare products to hospitals, emergency medical service (EMS) providers, home care providers, physician offices, veterinarians, long-term care facilities and consumers through our direct sales force, distributors and original equipment manufacturer (OEM) partners, such as GE Healthcare, Hillrom, Mindray, Philips, Physio-Control and Zoll, just to name a few.

Our core measurement technologies are our breakthrough Measure-through Motion and Low Perfusion™ pulse oximetry, known as Masimo Signal Extraction Technology® (SET®) pulse oximetry, and advanced rainbow® Pulse CO-Oximetry parameters such as noninvasive hemoglobin (SpHb®), alongside many other modalities, including brain function monitoring, hemodynamic monitoring, regional oximetry, acoustic respiration rate monitoring, capnography and gas monitoring, nasal high-flow respiratory support therapy, patient position and activity tracking and neuromodulation technology solutions.

Our measurement technologies are available on many types of devices, from bedside hospital monitors like the Root® Patient Monitoring and Connectivity Hub, to various handheld and portable devices, and to the tetherless Radius-PPG®, Radius-VSM® and Masimo SafetyNet™ remote patient surveillance solution. The Masimo Hospital Automation™ Platform facilitates data integration, connectivity and interoperability through solutions like Patient SafetyNet™(1), Iris™, iSirona™, Replica® and UniView™ to facilitate more efficient clinical workflows and to help clinicians provide the best possible care, both in-person and remotely. Leveraging our expertise in hospital-grade technologies, we are also expanding our suite of products intended for use both inside and outside the hospital and products for personal home wellness , including Masimo Sleep™, a sleep quality solution, the Radius Tº™, a wireless wearable continuous thermometer, the Radius C® wireless thetherless capnograph and the Masimo W1™ a wrist-worn continuous biosensing health watch.

Non-healthcare

Our non-healthcare consumer audio business develops, manufactures, markets, sells and licenses premium and luxury audio sound products and related integration technologies. Our consumer audio products are sold direct-to-consumers or through authorized retailers and wholesalers. We also license certain audio technologies to select luxury automotive manufacturers such as BMW®, Maserati®, McLaren®, Polestar® and Volvo®. In addition, we maintain partnerships with certain airlines for bespoke headphones, allowing for the best in-flight audio experience. Our premium and luxury audio business includes iconic brands like Bowers & Wilkins®, Denon®, Marantz®, Polk®, Definitive Technology®, Classe®, Boston Acoustics® and HEOS® to meet differentiated consumers wants and needs.

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Outlook and Strategy

We are excited about the long-term prospects of patient care, hospital automation and advancing our initiatives of making hospital quality patient monitoring available in the home to meet consumer healthcare and wellness needs. Healthcare ecosystems are rapidly evolving and becoming visibly more interconnected. Accelerated by the need to adapt to the post-pandemic world, more patient care is moving closer to consumers’ homes. The widespread caregiver shortage demands transformative changes in the current healthcare space. Consumers will naturally gravitate toward products that can extend the reach of physicians without any compromise on the quality of care.

We sought differentiated growth opportunities to cross-leverage technologies, bringing our core clinically superior solutions into the “home” and “on-the-go” settings and bringing Sound United’s premium audio and system integration technologies into the hospital to advance hospital automation connectivity and cloud-based technologies. The technology and expertise within Sound United will serve us well as we aim to augment our hospital-to-home strategy, providing innovative solutions to improve patient outcomes and reduce the cost of care. Furthermore, Sound United unlocks access to large, well-established consumer channels by offering us immediate scale with leading retail establishments across the U.S. and Europe. These collaborations will translate into products that broaden our access to untapped consumer demographics around the world. Please see Part I, Item 1 of this Annual Report on Form 10-K for additional information related to our business, products and technologies.

COVID-19 Pandemic

The COVID-19 pandemic continues to create uncertainty in the U.S. and around the globe, resulting in both challenges and opportunities for our business. Given the continuing uncertainties related to the COVID-19 pandemic, we cannot predict how it will continue to affect our product demand or our product mix. In addition, the increase in demand we experienced due to the COVID-19 pandemic could result in potential reductions in future demand if our customers have over purchased our products and need to consume their excess inventory before purchasing additional products. Furthermore, we continue to be exposed to potential disruptions to our manufacturing operations and disruptions in the supply of critical manufacturing components and in our workforce as circumstances surrounding the global impact of the COVID-19 pandemic continue to change. As a federal contractor, we expect that our employees are vaccinated per the federal mandate, and current employees and candidates seeking employment with us may be opposed to being vaccinated and may risk possible termination or may seek employment with an employer that is not required to follow the federal mandate. Please see “Risks Related to Our Revenues” and “Risks Related to our Business and Operations” in Part I, Item 1A of this Annual Report on Form 10-K for additional information on potential negative impacts to us resulting from the COVID-19 pandemic.

Stock Repurchase Program

In June 2022, the Board approved a new stock repurchase program, authorizing us to purchase up to 5.0 million shares of our common stock on or before December 31, 2027 (2022 Repurchase Program). The 2022 Repurchase Program may be carried out at the discretion of a committee comprised of our CEO and CFO through open market purchases, one or more Rule 10b5-1 trading plans, block trades and in privately negotiated transactions. For additional information regarding our current and prior stock repurchase programs, see Part II, Item 5 and Note 19 “Equity” to our accompanying consolidated financial statements included in Part IV, Item 15(a) of this Annual Report on Form 10-K.

Supply Chain and Inflationary Pressures

Uncertainty surrounding macroeconomic factors globally, including with respect to the supply chain environment, inflationary pressures, rising interest rates, labor shortages, and significant disruption in the capital markets, including as a result of the Russia and Ukraine conflict, may result in a recession, which could have a material adverse effect on our long-term business. For example, we have experienced supply constraints with regard to certain digital signal processor chips and other components during the COVID-19 pandemic, which negatively affected our sales during 2022, and may adversely affect our future sales. However, despite on-going supply chain uncertainties, logistical challenges and the global staffing challenges caused by COVID-19, we are optimistic about our long-term growth opportunities in both the healthcare and non-healthcare segments as our broad portfolio of products and solutions are well-suited to address patient and customer needs.

Russian-Ukraine Conflict

In response to the ongoing conflict in Ukraine, we continue to monitor the developing situation with respect to ongoing business in Russia and the Ukraine, and are working on appropriate contingency plans that will support our desire to serve existing patient populations while remaining compliant with all applicable U.S. and EU sanctions and regulations. While Russia and Ukraine do not constitute a material portion of our business, a significant escalation or expansion of economic disruption or the conflict’s current scope could have an impact on our business. In the interim, order acceptance for these countries has been halted. For the year ended December 31, 2022, sales derived from customers based in Russia represented an immaterial percentage of our total revenue.

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Results of Operations

The following table sets forth, for the periods indicated, our results of operations expressed as U.S. Dollar amounts and as a percentage of revenue:

Comparison of the Year ended December 31, 2022 to the Year ended January 1, 2022

Revenue. Revenue increased $796.6 million, or 64.3%, to $2,035.8 million for the year ended December 31, 2022, from $1,239.2 million for the year ended January 1, 2022. Contributing to the increase in revenue was approximately $695.5 million, or 34.2%, from the Sound United Acquisition and approximately $101.1 million, or 8.2%, as compared to the year ended January 1, 2022, from our healthcare business.

Revenue by segment: Revenue by segment is comprised of healthcare and non-healthcare segments. The healthcare segment consists of professional healthcare and consumer health products and services. The non-healthcare segment consists of consumer audio and related products and services. The following table details our revenues by segment for each of the year ended December 31, 2022 and January 1, 2022:

The increase in healthcare segment revenue was primarily due to higher revenue from consumables, parameters and services, which was partially offset by the impact of unfavorable foreign exchange rate movements from the prior year that decreased the U.S. Dollar translation of foreign sales that were denominated in various foreign currencies. Revenue generated through our direct and distribution sales channels increased $93.6 million, or 8.5%, to $1,192.7 million for the year ended December 31, 2022, compared to $1,099.1 million for the year ended January 1, 2022. Revenues from our OEM channel increased $7.5 million, or 5.4%, to $147.6 million for the year ended December 31, 2022 as compared to $140.1 million for the year ended January 1, 2022.

During the year ended December 31, 2022, we shipped approximately 307,600 noninvasive technology boards and monitors, an increase of approximately 18,600 units, or 6.4% over the year ended January 1, 2022.

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The non-healthcare revenue segment is a new reportable segment resulting from the Sound United Acquisition. The non-healthcare segment saw strong demand for consumer audio products, which was partially offset by the impact of unfavorable foreign exchange rate movements from the prior year that decreased the U.S. Dollar translation of foreign sales that were denominated in various foreign currencies.

Gross Profit. Gross profit consists of revenue less cost of goods sold. Cost of goods sold includes labor, material, overhead and other similar costs related to the production, supply, distribution and support of our products. Our gross profit for the years ended December 31, 2022 and January 1, 2022 were as follows:

Gross profit as a percentage of revenue decreased to 52.0% for the year ended December 31, 2022, from 65.2% for the year ended January 1, 2022, primarily due to change in product revenue mix from the inclusion of non-healthcare product sales. Cost of goods sold increased $546.2 million to $977.0 million for the year ended December 31, 2022, from 430.8 million for the year ended January 1, 2022, primarily due to higher material, manufacturing and distribution costs associated with the overall increase in sales, the impact of the higher proportion of these types of costs inherent in the newly added non-healthcare segment and transaction costs incurred related to the Sound United Acquisition. Also impacting the increase in cost of goods sold are various expense inefficiencies related to the continued global supply chain constraints in the current logistics environment.

Selling, General and Administrative. Selling, general and administrative expenses consist primarily of salaries, stock-based compensation and related expenses for sales, marketing and administrative personnel, sales commissions, advertising and promotion costs, professional fees related to legal, accounting and other outside services, public company costs and other corporate expenses. Selling, general and administrative expenses for the years ended December 31, 2022 and January 1, 2022 were as follows:

Selling, general and administrative expenses increased $262.0 million, or 66.3%, to $657.4 million for the year ended December 31, 2022 from $395.4 million for the year ended January 1, 2022. This increase was primarily attributable to the Sound United Acquisition in the form of higher compensation and other employee-related costs of approximately $77.2 million, higher legal and professional fees of approximately $47.5 million, higher advertising and marketing-related expenses of approximately $43.9 million, higher occupancy and other office-related costs of approximately $38.1 million and higher transaction-related costs of approximately $34.6 million.

Research and Development. Research and development expenses consist primarily of salaries, stock-based compensation and related expenses for engineers and other personnel engaged in the design and development of our products. These expenses also include third-party fees paid to consultants, prototype and engineering supply expenses and the costs of clinical trials. Research and development expenses for the years ended December 31, 2022 and January 1, 2022 were as follows:

Research and development expenses increased $54.2 million, or 39.5%, to $191.4 million for the year ended December 31, 2022 from $137.2 million for the year ended January 1, 2022, primarily due to the Sound United Acquisition in the form of higher compensation and employee-related costs of approximately $29.3 million, higher engineering project costs of approximately $13.2 million, higher occupancy and other office-related costs of approximately $4.2 million and higher professional fees of approximately $1.1 million.

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Non-operating Loss. Non-operating loss consists primarily of interest income, interest expense and foreign exchange gains and losses. Non-operating loss for the years ended December 31, 2022 and January 1, 2022 was as follows:

Non-operating loss was $16.6 million for the year ended December 31, 2022 compared to $1.4 million of non-operating loss for the year ended January 1, 2022. This net increase of approximately $15.2 million was primarily due to approximately $1.8 million of interest income on cash deposits in combination with approximately $7.2 million of net realized and unrealized foreign currency denominated transactions, which were offset by interest expense incurred under our credit facility of approximately $25.7 million during the year ended December 31, 2022.

Provision for Income Taxes. Our provision for income taxes for the years ended December 31, 2022 and January 1, 2022 were as follows:

Our provision for income taxes was $49.9 million for the year ended December 31, 2022 compared to $44.8 million for the year ended January 1, 2022. Our effective tax rate was 25.8% for the year ended December 31, 2022 compared to 16.3% for the year ended January 1, 2022. This increase in our effective tax rate for the year ended December 31, 2022 resulted primarily from an decrease in the amount of excess tax benefits realized from stock-based compensation pursuant to Accounting Standards Update (ASU) No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09), of approximately $14.0 million compared to the year ended January 1, 2022.

We have made no provision for U.S. income taxes or foreign withholding taxes on approximately $322.6 million in accumulated earnings from our foreign subsidiaries as we expect that such amounts will continue to be indefinitely reinvested in operations outside the U.S. Our actual future effective income tax rate will depend on various factors, including the geographic composition of our pre-tax income, the amount of excess tax benefits realized from U.S. stock-based compensation, the amount of our research and development tax credits, the deductibility of executive compensation, changes in tax laws, changes in deferred tax asset valuation allowances and the recognition and derecognition of tax benefits associated with uncertain tax positions.

Comparison of the Year ended January 1, 2022 to the Year ended January 2, 2021

For a discussion regarding our financial condition and results of operations for the year ended January 1, 2022 as compared to the year ended January 2, 2021, refer to the discussion under the heading “Comparison of the Year ended January 1, 2022 to the Year ended January 2, 2021” in Item 7, which should be read in conjunction with Item 7, in each case, of our Annual Report on Form 10-K for the year ended January 1, 2022, filed with the SEC on February 16, 2022.

Liquidity and Capital Resources

Our principal sources of liquidity consist of our existing cash and cash equivalent balances, future funds expected to be generated from operations and available borrowing capacity under our credit facility. As of December 31, 2022, we had approximately $678.6 million in working capital, of which approximately $202.9 million was cash and cash equivalents. In addition to net working capital, we had approximately $52.1 million of available borrowing capacity (net of outstanding letters of credit) under our credit facility as compared to approximately $970.8 million in working capital and approximately $745.3 million in cash and cash equivalents at January 1, 2022.

We currently maintain a credit facility which provides $705.0 million of unsecured borrowings. The credit facility also provides for a sublimit of up to $50.0 million for the issuance of letters of credit. Proceeds from the credit facility are being used for general corporate, capital investment and expenditures and working capital needs. For additional information regarding the credit facility, see Note 15 to our accompanying consolidated financial statements included in Part IV, Item 15(a) of this Annual Report on Form 10-K.

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In managing our day-to-day liquidity and capital structure, we generally do not rely on foreign earnings as a source of funds. As of December 31, 2022, we had cash totaling $106.6 million held outside of the U.S., of which approximately $25.7 million was accessible without additional tax cost and approximately $37.7 million was accessible at an incremental estimated tax cost of up to $0.2 million. The tax cost on the remaining $43.3 million is not determinable at this time. We currently have sufficient funds on-hand and cash held outside the U.S. that is available without additional tax cost to fund our global operations. In the event funds that are treated as permanently reinvested are repatriated, we may be required to accrue and pay additional U.S. taxes to repatriate these funds.

Uses of Cash. Our cash requirements depend on numerous factors, including but not limited to market acceptance of our technologies, our continued ability to commercialize new products and to create or improve our technologies and applications, expansion of our global footprint through acquisitions and/or strategic investments in technologies or technology companies, hedging and derivative activities, investments in property and equipment, the renewal of our credit facility, the impact of disruptions to the manufacturing industry supply chain for key components resulting from the COVID-19 pandemic, inflation, repurchases of our stock under our authorized stock repurchase program, costs related to our domestic and international regulatory requirements and other long-term commitment and contingencies. For further details regarding our commitment and contingencies, see Note 24 to our accompanying consolidated financial statements included in Part IV, Item 15(a) of this Annual Report on Form 10-K.

Despite these investment requirements and potential expenditures, we anticipate that our existing cash and cash equivalents, amounts available under our credit facility and cash provided by operations will be sufficient to meet our working capital requirements, capital expenditures and other operational funding needs for the next 12 months and beyond.

Cash Flows

Operating Activities. Cash provided by operating activities for the year ended December 31, 2022 was $29.4 million which was primarily driven by net income of $143.5 million. This was increased by non-cash activities, including and depreciation and amortization of $136.1 million and stock-based compensation of $47.7 million, partially offset by a deferred income tax benefit of $39.3 million. Additional increases in operating cash resulted from changes in accounts payable, deferred costs and other contract assets and lease receivables of approximately $60.5 million, $28.1 million and $12.8 million, respectively, primarily due to the timing of payments. Additional increases to net income were changes in operating assets, including an increase in accounts receivable, inventories, deferred revenue and other contract-related liabilities, income tax payable of $138.5 million, $155.9 million, $28.1 million and $3.8 million, respectively, which were offset by increases in other non-current liabilities of $4.1 million, $16.1 million, $9.3 million, $7.4 million and $4.9 million, respectively.

Cash provided by operating activities for the year ended January 1, 2022 was $264.6 million and was primarily driven by net income of $229.6 million. This was increased by non-cash activities, including stock-based compensation of $44.7 million, and depreciation and amortization of $35.6 million, partially offset by a deferred income tax benefit of $15.1 million Additional increases in operating cash resulted from decreases in inventory, accounts payable, accrued liabilities, deferred revenue and other contract-related liabilities, other current assets and income tax payable of $13.5 million, $11.0 million $7.8 million, $7.1 million, $6.4 million and $6.4 million, respectively, primarily due to the timing of payments. Additional increases to net income were changes in operating assets, including an increase in accounts receivable, lease receivables, and deferred cost and other contract assets of $60.8 million, $16.1 million and $6.9 million, respectively.

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Investing Activities. Cash used in investing activities for the year ended December 31, 2022 was approximately $1,057.7 million, consisting primarily of approximately $999.7 million for business combinations, net of cash acquired, approximately $52.8 million for purchases of property and equipment, approximately $3.5 million for intangible assets related to capitalized patent and trademark costs and approximately $1.7 million related to the acquisition of a strategic investment.

Cash used in investing activities for the year ended January 1, 2022 was approximately $37.5 million, consisting primarily of approximately $25.5 million for purchases of property and equipment, approximately $9.4 million for intangible assets related to capitalized patent and trademark costs and approximately $2.6 million related to the acquisition of a strategic investment.

Financing Activities. Cash used in financing activities for the year ended December 31, 2022 was approximately $520.4 million, consisting primarily of proceeds from borrowings under the line of credit of approximately $1,083.9 million and the issuance of common stock related to employee equity awards of approximately $8.1 million, which were partially offset by the repurchases of our common stock of approximately $401.5 million, repayments under the revolving line of credit of approximately $135.4 million, withholding of shares for employee payroll taxes for vested equity awards of approximately $25.4 million and debt issuance costs of approximately $9.3 million.

Cash used in financing activities for the year ended January 1, 2022 was approximately $122.4 million, resulting primarily from cash paid for common stock repurchase transactions that settled during the year of approximately $128.9 million, which were partially offset by proceeds from the issuance of common stock (upon exercise of options) of approximately $23.2 million.

Critical Accounting Estimates

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgements that affect the reported amounts of net revenues, expenses, assets and liabilities. These estimates and judgements are based on historical experience and on various other factors that are believed to be reasonable under the circumstances, and form the basis for making management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain. Although we regularly evaluate these estimates and assumptions, changes in judgments and uncertainties relating to these estimates could potentially result in materially different results under different assumptions and conditions. If these estimates differ significantly from actual results, the impact to the consolidated financial statements may be material. We believe that the critical accounting policies that are the most significant for purposes of fully understanding and evaluating our reported financial results include the following:

Revenue Recognition, Deferred Revenue and Other Contract Liabilities

We derive the majority of our revenue from four primary sources: (i) direct sales under deferred equipment agreements with end-user hospitals where we provide up-front monitoring equipment at no up-front charge in exchange for a multi-year sensor purchase commitment; (ii) other direct sales of noninvasive monitoring solutions to end-user hospitals, emergency medical response organizations and other direct customers; (iii) sales of noninvasive monitoring solutions to distributors who then typically resell to end-user hospitals, emergency medical response organizations and other customers; and (iv) sales of integrated circuit boards to OEM customers who incorporate our embedded software technology into their multiparameter monitoring devices. Subject to customer credit considerations, the majority of such sales are made on open account using industry standard payment terms based on the geography within which the specific customer is located.

We generally recognize revenue following a single, principles-based five-step model to be applied to all contracts with customers and generally provide for the recognition of revenue in an amount that reflects the consideration to which we expect to be entitled, net of allowances for estimated returns, discounts or sales incentives, as well as taxes collected from customers that are remitted to government authorities, when control over the promised goods or services are transferred to the customer. Revenue related to equipment supplied under sales-type lease arrangements is recognized once control over the equipment is transferred to the customer, while revenue related to equipment supplied under operating-type lease arrangements is generally recognized on a straight-line basis over the term of the lease.

While the majority of our sales transactions contain standard business terms and conditions, there are some transactions that contain non-standard business terms and conditions. As a result, contract interpretation and analysis is required to determine the appropriate accounting, including: (i) the amount of the total consideration, including variable consideration, (ii) whether the arrangement contains an embedded lease, and if so, whether such embedded lease is a sales-type lease or an operating lease, (iii) the identification of the distinct performance obligations contained within the arrangement, (iv) how the arrangement consideration should be allocated to each performance obligation when multiple performance obligations exist, including the determination of standalone selling price, and (v) when to recognize revenue on the performance obligations. Changes in judgments on these assumptions and estimates could materially impact the timing of revenue recognition.

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We enter into agreements to sell our monitoring solutions and services, sometimes as part of arrangements with multiple performance obligations that include various combinations of distinct product sales, equipment leases and services. In the case of contracts with multiple performance obligations, the authoritative guidance provides that the total consideration be allocated to each performance obligation on the basis of relative standalone selling prices. When a standalone selling price is not readily observable, we estimate the standalone selling price by considering multiple factors including, but not limited to, features and functionality of the product, geographies, type of customer, contractual prices pursuant to Group Purchasing Organization (GPO) contracts, our pricing and discount practices, and other market conditions.

Sales under deferred equipment agreements are generally structured such that we agree to provide certain monitoring-related equipment, software, installation, training and/or warranty support at no up-front charge in exchange for the customer’s commitment to purchase sensors over the term of the agreement, which generally ranges from three to six years. We allocate contract consideration under deferred equipment agreements containing fixed annual sensor purchase commitments to the underlying lease and non-lease components at contract inception. In determining whether any underlying lease components are related to a sales-type lease or an operating lease, we evaluate the customer’s rights and ability to control the use of the underlying equipment throughout the contract term, including any equipment substitution rights retained by us, as well as our expectations surrounding potential contract/lease extensions or renewals and the customer’s likelihood to exercise any purchase options. Revenue allocable to non-lease components is generally recognized as such non-lease components are satisfied. Revenue allocable to lease components under sales-type lease arrangements is generally recognized when control over the equipment is transferred to the customer. Revenue allocable to lease components under operating lease arrangements is generally recognized over the term of the operating lease. We generally do not expect to derive any significant value in excess of such asset’s unamortized book value from equipment underlying our operating leases arrangements.

Revenue from direct sales of our products to end-user hospitals, emergency medical response organizations, other direct customers, distributors and OEM customers is generally recognized by us when control of such products transfer to the customer based upon the terms of the contract or underlying purchase order. Revenue related to OEM rainbow® parameter software licenses is recognized by us upon the OEM’s shipment of its product to its customer, as reported to us by the OEM.

We provide certain customers with various sales incentives that may take the form of discounts or rebates. We estimate and provide allowances for these programs as a reduction to revenue at the time of sale. In general, customers do not have a right of return for credit or refund. However, we allow returns under certain circumstances. At the end of each period, we estimate and accrue for these returns as a reduction to revenue. We estimate the revenue constraints related to these forms of variable consideration based on various factors, including expected purchasing volumes, prior sales and returns history, and specific contractual terms and limitations.

Inventory

Inventories are stated at the lower of cost or net realizable value. Cost is determined using a standard cost method, which approximates first-in, first-out method and includes material, labor and overhead costs. Inventory valuation reserves are recorded for materials that have become excess or obsolete or are no longer used in current production and for inventory items that have a market price less than the carrying value in inventory. We generally purchase raw materials in quantities that we anticipate will be fully used within one year. However, changes in operating strategy and customer demand, and frequent unpredictable fluctuations in market values for such materials, can limit our ability to effectively utilize all of the raw materials purchased and sold through resulting finished goods to customers for a profit. We regularly monitor potential inventory excess, obsolescence and lower market values compared to standard costs and, when necessary, reduce the carrying amount of our inventory to its market value.

We determine any required inventory valuation adjustments based on an evaluation of the expected future use of our inventory on an item by item basis. We apply historical obsolescence rates to estimate the loss on inventory expected to have a recovery value below cost. Our historical obsolescence rates are developed from our company specific experience for major categories of inventory, which are then applied to excess inventory on an item by item basis. We also record other specific inventory valuation adjustments when we become aware of other unique events that result in a known recovery value below cost. For inventory items that have been written down, the reduced value becomes the new cost basis. If our assumptions, judgements or estimates for potential inventory losses prove to be too low, our future earnings will be affected when any related additional inventory losses are recorded.

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Stock-Based Compensation

Our stock-based compensation awards are currently comprised of stock options, restricted stock units (RSUs) and performance share units (PSUs), all of which are equity-classified awards. For equity-classified awards granted on or after January 1, 2006, we estimate the fair value of the award on the date of grant and expense stock-based compensation over the requisite service period. In the case of PSUs, the amount of expense recognized is also dependent upon the expected achievement level for the specified performance criteria. The fair value of RSU and PSU awards is the closing price of our common stock on the grant date. To calculate the fair value of stock option awards, we use the Black-Scholes option pricing model, which, in addition to the closing price of our stock on the grant date and the option strike price, requires the input of subjective assumptions. These assumptions include the estimated length of time employees will retain their stock options before exercising them (the expected term), the estimated volatility of our stock price over the expected term and the dividend yield on our common stock. We estimate expected term based on both our specific historical option exercise experience, as well as expected term information available from a peer group of companies with similar vesting schedules. The estimated volatility is based on both the historical and implied volatilities of our share price.

Changes in the types and quantity of equity awards, as well as the fair market value of our stock may impact the cost of future stock option grants. In general, to the extent that the fair market value of our stock increases, the overall cost of granting these options will also increase. Any changes in the assumptions, judgments and estimates mentioned above could cause our actual stock-based compensation expense to vary, resulting in changes to future earnings. For further details regarding our stock-based compensation see Note 20 to our accompanying consolidated financial statements included in Part IV, Item 15(a) of this Annual Report on Form 10-K.

Accounting for Income Taxes

We account for income taxes using the asset and liability method, under which we recognize deferred tax assets and liabilities for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for net operating loss and tax credit carryforwards. A tax position that meets a more-likely-than-not recognition threshold is recognized in the first reporting period that it becomes more-likely-than-not such tax position will be sustained upon examination. A tax position that meets this more-likely-than-not recognition threshold is recorded at the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Previously recognized income tax positions that fail to meet the recognition threshold in a subsequent period are derecognized in that period. Differences between actual results and our assumptions, or changes in our assumptions in future periods, are recorded in the period they become known. We record potential accrued interest and penalties related to unrecognized tax benefits in income tax expense.

As a multinational corporation, we are subject to complex tax laws and regulations in various jurisdictions. The application of tax laws and regulations is subject to legal and factual interpretation, judgment and uncertainty. Tax laws themselves are subject to change as a result of changes in fiscal policy, changes in legislation, evolution of regulations and court rulings. We have concluded all U.S. federal income tax matters for years through 2018 and all material state, local and foreign income tax matters for years through 2015. Given the foregoing, our actual liability for U.S. or foreign taxes may be materially different from our estimates, which could result in the need to record additional liabilities or potentially to reverse previously recorded tax liabilities.

Deferred tax assets (DTA) and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. A valuation allowance is recorded against any deferred tax assets when, in the judgment of management, it is more likely than not that all or part of a deferred tax asset will not be realized. In assessing the need for a valuation allowance, we consider all positive and negative evidence, including recent financial performance, scheduled reversals of temporary differences, projected future taxable income, availability of taxable income in carryback periods and tax planning strategies.

Income taxes are highly susceptible to changes from period to period, requiring management to make assumptions about our future income over the lives of our DTAs and the impact of changes in valuation allowances. Any difference in the assumptions, judgments and estimates mentioned above could results in changes to our results of operations.

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Litigation Costs and Contingencies

We record a charge equal to at least the minimum estimated liability for a loss contingency or litigation settlement when both of the following conditions are met: (i) information available prior to issuance of the financial statements indicates that it is probable that a liability had been incurred at the date of the financial statements and (ii) the range of loss can be reasonably estimated. The determination of whether a loss contingency or litigation settlement is probable or reasonably possible involves a significant amount of management judgment, as does the estimation of the range of loss given the nature of contingencies. Liabilities related to litigation settlements with multiple elements are recorded based on the fair value of each element. Legal and other litigation related expenses are recognized as the services are provided. We record insurance and other indemnity recoveries for litigation expenses when both of the following conditions are met: (i) the recovery is probable and (ii) collectability is reasonably assured. The insurance recoveries recorded are only to the extent the litigation costs have been incurred and recognized in the financial statements; however, it is reasonably possible that the actual recovery may be significantly different from our estimates. There are many uncertainties associated with any litigation, and we cannot provide assurance that any actions or other third-party claims against us will be resolved without costly litigation or substantial settlement charges. If any of those events were to occur, our business, financial condition and results of operations could be materially and adversely affected.

Business Combinations

We account for business combinations using the acquisition method of accounting, which requires that once control is obtained, all the assets acquired, liabilities assumed and noncontrolling interest in the acquired entity, if applicable, are recorded at their respective fair values at the date of acquisition. The determination of fair values of identifiable assets and liabilities requires estimates and the use of valuation techniques when market value is not readily available. For intangible assets acquired in a business combination, we typically use the income method. Significant estimates in valuing certain intangible assets include, but are not limited to, the amount and timing of future cash flows, growth rates, discount rates and useful lives. The excess of the purchase price over fair values of identifiable assets, liabilities, and noncontrolling interest in the acquired entity, if applicable, is recorded as goodwill. Should any of the assumptions, judgements or estimates associated with the valuation components change, the fair value of the assets acquired could vary. Transaction costs associated with a business combination are expensed as incurred. During the measurement period, which is up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings.

Recent Accounting Pronouncements

For details regarding any recently adopted and recently issued accounting standards, see Note 2 to our accompanying consolidated financial statements included in Part IV, Item 15(a) of this Annual Report on Form 10-K.

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