MKS INC (MKSI) FY 2021 MD&A

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

The Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, describes principal factors affecting the results of our operations, financial condition, cash flows and liquidity, as well as our critical accounting policies and estimates that require significant judgment and thus have the most significant potential impact on our Consolidated Financial Statements, and is intended to better allow investors to view the Company from management’s perspective. This section focuses on material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be necessarily indicative of our future operating results or of our future financial condition. This section provides an analysis of our financial results for the year ended December 31, 2021 compared to the year ended December 31, 2020. For the discussion and analysis covering the year ended December 31, 2020 compared to the year ended December 31, 2019, please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2020, as filed with the SEC on February 23, 2021.

Overview

We are a global provider of instruments, systems, subsystems and process control solutions that measure, monitor, deliver, analyze, power and control critical parameters of advanced manufacturing processes to improve process performance and productivity for our customers. Our products are derived from our core competencies in pressure measurement and control, flow measurement and control, gas and vapor delivery, gas composition analysis, electronic control technology, reactive gas generation and delivery, power generation and delivery, vacuum technology, temperature sensing, lasers, photonics, optics, precision motion control, vibration control and laser-based manufacturing systems solutions. We also provide services relating to the maintenance and repair of our products, installation services and training. Our primary served markets include semiconductor, industrial technologies, life and health sciences and research and defense.

Recent Events

Acquisitions

On July 15, 2021, we completed our acquisition of Photon Control Inc. (“Photon Control” and such acquisition, the “Photon Control Acquisition”), pursuant to a definitive agreement. Photon Control designs, manufactures and distributes a wide range of optical sensors and systems to measure temperature and position used in semiconductor wafer fabrication. At the effective time of the Photon Control Acquisition, each share of Photon Control’s common stock issued and outstanding as of immediately prior to the effective time of the Photon Control Acquisition was converted into the right to receive 3.60 per share in cash, in Canadian dollars (“CAD”), without interest and subject to deduction for any required withholding tax. We paid to the former Photon Control securityholders aggregate consideration of CAD 379 million or $303 million, excluding related transaction fees and expenses. We funded the payment of the aggregate consideration with available cash on hand. Photon Control is included in our Light & Motion (“L&M”) segment.

The Photon Control Acquisition has helped us deliver on one of our long-term strategic objectives, which is to broaden our portfolio of key technologies to better serve our customers. The Photon Control Acquisition further advances our strategy to enhance our Surround the Chamber® offering by adding optical sensors for temperature control for critical etch and deposition applications in semiconductor wafer fabrication.

On July 1, 2021, we entered into a definitive agreement (as amended from time to time, the “Implementation Agreement”) to acquire Atotech, a leading process chemicals technology company and a market leader in advanced electroplating solutions. Pursuant to the Implementation Agreement, we agreed to pay $16.20 per share in cash and 0.0552 of a share of our common stock for each outstanding common share of Atotech. At the time of the announcement of the acquisition, the total value of the aggregate cash and stock consideration was approximately $5.1 billion. The final value of the consideration will be determined at the time of the closing of the acquisition, which is expected to occur in the first quarter of 2022, subject to the satisfaction of certain closing conditions, including receipt of regulatory approval from China and approval by the Royal Court of Jersey. Our obligations to complete the acquisition are not subject to any financing condition. We intend to fund the cash portion of the transaction with a combination of available cash on hand and committed term loan debt financing.  In connection with entering into the Implementation Agreement, we entered into (a) a commitment letter (the “Initial Commitment Letter”), dated as of July 1, 2021, with JPMorgan Chase Bank, N.A. and Barclays Bank PLC (collectively, the “Initial Commitment Parties”) and (b) joinders to the Initial Commitment Letter to add certain additional lender parties (the “Commitment Letter Joinders” and, together with the Initial Commitment Letter, the “Commitment Letter”) dated as of July 23, 2021, with the Initial Commitment Parties and the additional lenders party thereto  (collectively, the “Supplemental Commitment Parties” and, together with the Initial Commitment Parties, the “Commitment Parties”), pursuant to which, subject to the terms and conditions set forth therein, the Commitment Parties committed to provide (i) a senior

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secured term loan credit facility in an aggregate principal amount of $5.3 billion (the “New Term Loan Facility”) and (ii) a senior secured revolving credit facility with aggregate total commitments of $500 million (the “New Revolving Credit Facility”).  The New Term Loan Facility and New Revolving Credit Facility would refinance our existing term loan facility (the “Term Loan Facility”) and our existing asset-based revolving credit facility (the “ABL Facility”), respectively, and the New Term Loan Facility would be used to finance a portion of the acquisition and to refinance certain existing indebtedness of Atotech.

On October 22, 2021, we completed the syndication of the New Term Loan Facility, comprised of two tranches: a $4.7 billion loan at LIBOR plus 2.25%, a floor of 0.50% and 0.25% of original issue discount, and a Euro tranche of 0.5 billion Euro (“EUR”), or approximately $0.6 billion at EURIBOR plus 2.75%, a floor of 0.00% and 0.25% of original issue discount. Subsequent to the syndication, the $4.7 billion tranche is expected to be modified to reference a term rate based on SOFR (plus an applicable credit spread adjustment) as the benchmark rate.

The Commitment Parties’ obligations under the Commitment Letter and the closing and initial funding under the New Term Loan Facility are subject to certain customary conditions including, without limitation, the consummation of the acquisition of Atotech in accordance with the Implementation Agreement, the accuracy of specified representations and warranties of us and other customary closing conditions.

Segments and Markets

The Vacuum & Analysis (“V&A”) segment provides a broad range of instruments, components and subsystems which are derived from our core competencies in pressure measurement and control, flow measurement and control, gas and vapor delivery, gas composition analysis, electronic control technology, reactive gas generation and delivery, power generation and delivery, and vacuum technology.

The L&M segment provides a broad range of instruments, components and subsystems which are derived from our core competencies in lasers, photonics, optics, temperature sensing, precision motion control and vibration control.

The Equipment & Solutions (“E&S”) segment provides a range of products including laser-based systems for PCB manufacturing, which include flexible interconnect PCB processing systems and high-density interconnect solutions for rigid PCB manufacturing and substrate processing and MLCC test systems.

Semiconductor Market

A significant portion of our sales is derived from products sold to semiconductor capital equipment manufacturers and semiconductor device manufacturers. Our products are used in major semiconductor processing steps, such as depositing thin films of material onto silicon wafer substrates, etching, cleaning, lithography, metrology and inspection. The semiconductor industry continually faces new challenges as products become smaller, more powerful and highly mobile. Ultra-thin layers, smaller critical dimensions, new materials, 3D structures, and the ongoing need for higher yield and productivity drive the need for tighter process measurement and control, all of which MKS supports. We believe we are the broadest critical subsystem provider in the wafer fabrication equipment (“WFE”) ecosystem and address over 85% of the market.

Approximately 62% and 59% of our net revenues for 2021 and 2020, respectively, were from sales to semiconductor capital equipment manufacturers and semiconductor device manufacturers. We estimate global spending on WFE was approximately $80 billion in 2021 compared to approximately $56 billion in 2020, driven by increases in memory and logic and reflective of strong secular demand trends increasing semiconductor demand, such as robust data growth, 5G, Internet-Of-Things, artificial intelligence, and autonomous vehicles. We anticipate that the semiconductor market will continue to account for a substantial portion of our sales.

Net revenues in our semiconductor market increased by $439 million, or 32%, in 2021, compared to 2020, due to increases in net revenues in V&A and L&M, offset by decreases in net revenues in E&S. V&A net revenues in our semiconductor market increased $393 million due to broad-based increases in demand for V&A products. L&M net revenues in our semiconductor market increased $73 million, driven by demand for our photonics solutions in lithography, metrology and inspection, as well as contributions from our acquisition of Photon Control. These increases were offset by a decrease of $27 million in net revenues in E&S, resulting from the discontinuation of certain non-core products.

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The semiconductor capital equipment industry is subject to rapid demand shifts, which are difficult to predict, and we cannot be certain as to the timing or extent of future demand or any future weakness in the semiconductor capital equipment industry.

In 2021, we experienced supply chain disruptions, component shortages and significant price increases for certain components in our semiconductor market due to global capacity constraints compounded by increasing global demand as well as the ongoing COVID-19 pandemic. We expect these disruptions and shortages to continue in the near-term while our suppliers adjust to significant increases in demand and respond to the challenges posed by the COVID-19 pandemic, all of which may negatively impact net revenues from our semiconductor market for the three months ending March 31, 2022.

Advanced Markets

In addition to the semiconductor market, our products are used in the industrial technologies, life and health sciences, research and defense markets.

Industrial Technologies

Industrial technologies encompasses a wide range of diverse applications, including advanced electronics manufacturing comprising flexible and rigid printed circuit board (“PCB”) processing/fabrication, electronic component manufacturing, glass coating and electronic thin films. Electronic thin films are a primary component of numerous electronic products including flat panel displays, light emitting diodes, solar cells and data storage media. Other applications include laser marking, measurement and scribing, natural gas and oil production and environmental monitoring.

Life and Health Sciences

Our products for life and health sciences are used in a diverse array of applications, including bioimaging, medical instrument sterilization, medical device manufacturing, analytical, diagnostic and surgical instrumentation, consumable medical supply manufacturing and pharmaceutical production.

Research and Defense

Our products for research and defense are sold to government, university and industrial laboratories for applications involving research and development in materials science, physical chemistry, photonics, optics and electronics materials. Our products are also sold for monitoring and defense applications including surveillance, imaging and infrastructure protection.

Approximately 38% and 41% of our net revenues in the years ended December 31, 2021 and 2020, respectively, were from advanced markets.

Net revenues from customers in our advanced markets increased by $180 million, or 19%, in 2021, compared to 2020, with E&S, V&A and L&M recording net revenue increases of $67 million, $62 million and $51 million, respectively. Net revenues in our industrial technologies market increased $164 million, primarily in advanced electronics manufacturing applications such as PCB processing/fabrication and electronic component manufacturing. Net revenues in our research and defense market increased $11 million, due to a rebound in demand following university and research lab closures in the first half of 2020 caused by the COVID-19 pandemic.

International Markets

A significant portion of our net revenues is from sales to customers in international markets. International net revenues accounted for approximately 57% and 55% of our total net revenues in 2021 and 2020, respectively. A significant portion of our international net revenues was from China, Israel, Japan, South Korea and Taiwan. Long-lived assets located outside of the United States accounted for approximately 25% and 28% of our total long-lived assets in 2021 and 2020, respectively. Long-lived assets include, property, plant and equipment, net, right-of-use assets, and certain other assets and exclude goodwill, intangible assets and long-term tax-related accounts.

Critical Accounting Policies and Estimates

The MD&A discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). The preparation of these financial statements requires

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management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition, inventory, warranty costs, pension plan valuations, stock-based compensation expense, intangible assets, goodwill and other long-lived assets and income taxes. We base our estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the most significant judgments, assumptions and estimates we use in preparing our consolidated financial statements:

Revenue Recognition. We account for revenue using Accounting Standards Codification 606 (“ASC 606”). We apply ASC 606 using the following steps:

Revenue under ASC 606 is recognized when or as obligations under the terms of a contract with our customer has been satisfied and control has transferred to the customer. The majority of our performance obligations, and associated revenue, are transferred to customers at a point in time, generally upon shipment of a product to the customer or receipt of the product by the customer and without significant judgments. Installation services are not significant and are usually completed in a short period of time (normally less than two weeks) and therefore, recorded at a point in time when the installation services are completed, rather than over time as they are not material. Extended warranty, service contracts, and repair services, which are transferred to the customer over time, are recorded as revenue as the services are performed. For repair services, we make an accrual at each quarter end based upon historical repair times within our product groups to record revenue based upon the estimated number of days completed to date, which is consistent with ratable recognition. Customized products with no alternative future use to us, and that have an enforceable right to payment for performance completed to date, are also recorded over time. We consider this to be a faithful depiction of the transfer to the customer of revenue over time as the work is performed or service is delivered, ratably over time. The adjustments for custom products were not material for 2021 or 2020.

Revenue is measured as the amount of consideration we expect to receive in exchange for transferring goods or providing services. Performance obligations promised in a contract are identified based on the products or services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the product or service either on its own or together with other resources that are readily available from third parties or from us, and are distinct in the context of the contract, whereby the transfer of the product or service is separately identifiable from other promises in the contract. Sales, value add, and other taxes we collect concurrent with revenue-producing activities are excluded from revenue. Our normal payment terms are 30 to 60 days but vary by the type and location of our customers and the products or services offered. The time between invoicing and when payment is due is not significant. For certain products and services and customer types, we require payment before the products or services are delivered to, or performed for, the customer. None of our contracts as of December 31, 2021 contained a significant financing component.

We periodically enter into contracts with our customers in which a customer may purchase a combination of goods and or services, such as products with installation services or extended warranties. These contracts include multiple promises that we evaluate to determine if the promises are separate performance obligations. Once we determine the performance obligations, we then determine the transaction price, which includes estimating the amount of variable consideration to be included in the transaction price, if any. To the extent the transaction price includes variable consideration, we estimate the amount of variable consideration that should be included in the transaction price utilizing either the expected value method or the most likely amount method depending on the method we expect to better predict the amount of consideration to which it will be entitled. There are no constraints on the variable consideration recorded. We then allocate the transaction price to each performance obligation in the contract based on a relative stand-alone selling price charged separately to customers or using an expected cost-plus margin method. The corresponding revenues are recognized when or as the related performance obligations are satisfied, which are noted above. The impact of variable consideration has been immaterial.

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We sometimes sell separately priced service contracts and extended warranty contracts related to certain of our products, especially our laser products. The separately priced contracts generally range from 12 to 60 months. We normally receive payment at the inception of the contract or beginning of an annual period and recognize revenue over the term of the agreement in proportion to the costs expected to be incurred in satisfying the obligations under the contract.

We monitor and track the amount of product returns, provide for sales return allowances and reduce revenue at the time of shipment for the estimated amount of such future returns, based on historical experience. While product returns have historically been within our expectations and the provisions established, there is no assurance that we will continue to experience the same return rates that we have in the past. Any significant increase in product return rates could have a material adverse impact on our operating results for the period or periods in which such returns materialize.

While we maintain a credit approval process, significant judgments are made by management in connection with assessing our customers’ ability to pay at the time of shipment. Despite this assessment, from time to time, our customers are unable to meet their payment obligations. We continuously monitor our customers’ credit worthiness and use our judgment in establishing a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the provisions established, there is no assurance that we will continue to experience the same credit loss rates that we have in the past. A significant change in the liquidity or financial position of our customers could have a material adverse impact on the collectability of accounts receivable and our future operating results. Bad debt expense was immaterial in 2021 and 2020.

Inventory. We value our inventory at the lower of cost (first-in, first-out method) or market. We regularly review inventory quantities on hand and record a provision to write-down excess and obsolete inventory to its estimated net realizable value, if less than cost, based primarily on our estimated forecast of product demand. Once our inventory value is written-down and a new cost basis has been established, the inventory value is not increased due to demand increases. Demand for our products can fluctuate significantly. A significant increase in the demand for our products could result in a short-term increase in the cost of inventory purchases as a result of supply shortages or a decrease in the cost of inventory purchases as a result of volume discounts, while a significant decrease in demand could result in an increase in the charges for excess inventory quantities on hand. In addition, our industry is subject to technological change, new product development and product technological obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. Therefore, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our reported operating results. Excess and obsolete expense was $16 million and $25 million for 2021 and 2020, respectively.

Warranty Costs. We provide for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue. We provide warranty coverage for our products for periods ranging from 12 to 36 months, with the majority of our products for periods ranging from 12 to 24 months. Short-term accrued warranty obligations, which expire within one year, are included in other current liabilities and long-term accrued warranty obligations are included in other liabilities in the consolidated balance sheets. We estimate the anticipated costs of repairing our products under such warranties based on the historical costs of the repairs and any known specific product issues. The assumptions we use to estimate warranty accruals are re-evaluated periodically in light of actual experience and, when appropriate, the accruals are adjusted. Our determination of the appropriate level of warranty accrual is based upon estimates. Should product failure rates differ from our estimates, actual costs could vary significantly from our expectations. Defective products will be either repaired or replaced, generally at our option, upon meeting certain criteria.

Pension Plans. Several of our non-U.S. subsidiaries have defined benefit pension plans covering employees of those subsidiaries. Some of the plans are unfunded, as permitted under the plans and applicable laws. For financial reporting purposes, we obtained actuarial reports supporting the calculation of net periodic pension costs that used a number of actuarial assumptions, including a discount rate for plan obligations, an assumed rate of return on pension plan assets and an assumed rate of compensation increase for employees covered by the various plans. We reviewed these actuarial assumptions and concluded they were reasonable based upon our judgment, considering known trends and uncertainties. Actual results that differ from these assumptions would impact future expense recognition and the cash funding requirements of our pension plans.

Stock-Based Compensation Expense. We record compensation expense for all stock-based compensation awards to employees and directors based upon the estimated fair market value of the underlying instrument. Accordingly, stock-based compensation cost is measured at the grant date, based upon the fair value of the award.

We typically issue restricted stock units (“RSUs”) as stock-based compensation. We also provide certain employees the opportunity to purchase our shares through an Employee Stock Purchase Plan (“ESPP”). For RSUs, the fair value is the closing

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market price of the stock on the date of grant. We estimate the fair value of shares issued under our ESPP using the Black-Scholes pricing model, which incorporates a number of complex and subjective variables, including expected stock price volatility over the term of the awards, expected life, risk free interest rate and expected dividends. Management determined that blended volatility, a combination of historical and implied volatility, is more reflective of market conditions and a better indicator of expected volatility than historical or implied volatility alone.

Certain RSUs involve stock to be issued upon the achievement of performance conditions (“performance shares”) under our stock incentive plan. Such performance shares become available, subject to time-based vesting conditions if, and to the extent that, financial performance criteria for the applicable period are achieved. Accordingly, the number of performance shares earned will vary based on the level of achievement of financial performance objectives for the applicable period. Until such time that our financial performance can ultimately be determined, each quarter we estimate the number of performance shares to be earned based on an evaluation of the probability of achieving the financial performance objectives. Such estimates are revised, if necessary, in subsequent periods when the underlying factors change our evaluation of the probability of achieving the financial performance objectives. Accordingly, share-based compensation expense associated with performance shares may differ significantly from the amount recorded in the current period.

The assumptions used in calculating the fair value of share-based compensation awards represents management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.

Intangible Assets, Goodwill and Other Long-Lived Assets.  As a result of our acquisitions, we have identified intangible assets and generated significant goodwill. Definite-lived intangible assets are valued based on estimates of future cash flows and amortized over their estimated useful life. Determining fair value requires the exercise of significant judgment, including assumptions about appropriate discount rates as well as forecasted revenue, gross profit and operating margins.

Goodwill and indefinite-lived intangible assets are subject to annual impairment testing as well as testing upon the occurrence of any event that indicates a potential impairment. Intangible assets and other long-lived assets are also subject to an impairment test if there is an indicator of impairment. If our expectations of future results and cash flows are significantly diminished, intangible assets and goodwill may be impaired and the resulting charge to operations may be material. When we determine that the carrying value of intangibles or other long-lived assets may not be recoverable based upon the existence of one or more indicators of impairment, we use the projected undiscounted cash flow method to determine whether an impairment exists, and then measure the impairment using discounted cash flows. To measure impairment for goodwill, we compare the fair value of our reporting units by measuring discounted cash flows to the book value of the reporting units. Goodwill would be impaired if the resulting implied fair value was less than the recorded book value of the goodwill.

The estimation of useful lives and expected cash flows require us to make significant judgments regarding future periods that are subject to some factors outside of our control. Changes in these estimates can result in significant revisions to the carrying value of these assets and may result in material charges to the results of operations.

We have elected to perform our annual goodwill impairment test as of October 31 of each year, or more often if events or circumstances indicate that there may be impairment. Goodwill is the amount by which the cost of acquired net assets exceeded the fair value of those net assets on the date of acquisition. We allocate goodwill to reporting units at the time of acquisition or when there is a change in the reporting structure and base that allocation on which reporting units will benefit from the acquired assets and liabilities. Reporting units are defined as operating segments or one level below an operating segment, referred to as a component. The estimated fair value of our reporting units was based on discounted cash flow models derived from internal earnings and internal and external market forecasts. Determining fair value requires the exercise of significant judgment, including assumptions about appropriate discount and perpetual growth rates, as well as forecasted revenue growth rates and gross profit and operating margins. Discount rates are based on a weighted average cost of capital (“WACC”), which represents the average rate a business must pay its providers of debt and equity. The WACC used to test goodwill is derived from a group of comparable companies. Assumptions in estimating future cash flows are subject to a high degree of judgment and complexity. We make every effort to forecast these future cash flows as accurately as possible with the information available at the time the forecast is developed.

In performing our annual goodwill impairment test, we are permitted to first assess qualitative factors to determine whether it is more likely than not that the fair value of our reporting unit is less than its carrying amount, including goodwill. In performing the qualitative assessment, we consider certain events and circumstances specific to the reporting unit and to the entity as a whole, such as macroeconomic conditions, industry and market considerations, overall financial performance and cost factors when evaluating whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount. We are also permitted to bypass the qualitative assessment and proceed directly to the quantitative test. If we choose to

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undertake the qualitative assessment and we conclude that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, we would then proceed to the quantitative impairment test. In the quantitative assessment, we compare the fair value of the reporting unit to its carrying amount, which includes goodwill. If the fair value exceeds the carrying value, no impairment loss exists. If the fair value is less than the carrying amount, a goodwill impairment loss is measured and recorded.

As of October 31, 2021, we performed our annual impairment assessment of goodwill using a qualitative assessment for all of our reporting units. We determined that it was more likely than not that the fair values were more than the carrying values for each of the reporting units.

We will continue to monitor and evaluate the carrying value of goodwill. If market and economic conditions or business performance deteriorate, this could increase the likelihood of us recording an impairment charge.

Income Taxes. We evaluate the realizability of our net deferred tax assets and assess the need for a valuation allowance on a quarterly basis. The future benefit to be derived from our deferred tax assets is dependent upon our ability to generate sufficient future taxable income in each jurisdiction of the right type to realize the assets. We record a valuation allowance to reduce our net deferred tax assets to the amount that is expected to be realized. To the extent we establish a valuation allowance an expense is recorded within the provision for income taxes line in the consolidated statements of operations and comprehensive income.

Accounting for income taxes requires a two-step approach to recognize and measure uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if, based on the technical merits, it is more likely than not that the position will be sustained upon audit, including resolutions of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. We re-evaluate these uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit and new audit activity. Any change in these factors could result in the recognition of a tax benefit or an additional charge to the tax provision.

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Results of Operations

The following table sets forth, for the periods indicated, the percentage of total net revenues of certain line items included in our consolidated statements of operations and comprehensive income data:

Year Ended December 31, 2021 compared to 2020

Net Revenues

Net product revenues increased $564 million in 2021, compared to 2020. Net product revenues from our semiconductor market increased $394 million due to broad-based increases in demand for semiconductor capital equipment across memory, foundry and logic manufacturing applications and contributions from Photon Control, offset by a decrease in net revenues from E&S, due to a discontinuation of certain non-core products. Net revenues from our top ten customers accounted for 47%, 44% and 33% of net revenues for 2021, 2020 and 2019, respectively, with the increasing percentages attributable to increasing semiconductor market sales. As a percentage of net revenues from our top ten customers, semiconductor market revenue accounted for greater than 90% in each of these years. The semiconductor market has historically experienced cyclical variations in product supply and demand. It is subject to rapid demand shifts, which are difficult to predict, and we cannot be certain as to the timing or extent of future demand or any future weakness in the semiconductor capital equipment industry. For example, our semiconductor market revenue sequentially increased 32% in 2021, sequentially increased 49% in 2020, and sequentially decreased 19% in 2019. We believe net revenues attributable to our semiconductor market customers are affected by the cyclical nature of the semiconductor market.

Net product revenues in advanced markets increased $169 million due to increased net revenue from our industrial technologies markets, primarily in advanced electronics manufacturing applications such as PCB processing/fabrication and

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electronic component manufacturing. Net product revenues in our research and defense market also increased due to a rebound in demand following university and research lab closures in the first half of 2020 caused by the COVID-19 pandemic.

Net service revenues consisted mainly of fees for services related to the maintenance and repair of our products, sales of spare parts, and installation and training. Service revenues increased $56 million in 2021, compared to 2020. Net service revenues from our semiconductor customers increased $45 million and net service revenues from advanced market customers increased $11 million, both reflective of higher product revenues in both markets.

Total international net revenues, including product and service, were $1.7 billion in 2021, compared to $1.3 billion in 2020. The increase in 2021 was primarily due to increases in net revenues from China, Japan, South Korea and Taiwan.

The following table sets forth our net revenues by reportable segment:

Net Revenues

Net revenues for our V&A segment increased $456 million in 2021, compared to 2020, due to a volume increase of $393 million from our semiconductor customers and an increase of $63 million from our advanced markets customers, primarily from customers in our industrial technologies market.

Net revenues for our L&M segment increased $124 million in 2021, compared to 2020, due to an increase of $73 million from our semiconductor customers and an increase of $51 million from our advanced markets customers, primarily from customers in our industrial technologies market.

Net revenues from our E&S segment increased $40 million in 2021, compared to 2020, due to an increase of $67 million from our advanced markets customers, primarily from customers in our industrial technologies market, partially offset by a decrease of $27 million from our semiconductor customers, resulting from the discontinuation of certain non-core products.

The following table sets forth gross profit as a percentage of net revenues by product and service:

Gross Profit

Gross profit as a percentage of net product revenues increased by 1.7 percentage points in 2021, compared to 2020, primarily due to higher revenue volumes and favorable product mix.

Gross profit as a percentage of net service revenues increased by 1.7 percentage points in 2021, compared to 2020, primarily due to higher utilization of service technicians.

The following table sets forth gross profit as a percentage of net revenues by reportable segment:

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Gross Profit

Gross profit as a percentage of net revenues for our V&A segment increased primarily due to higher revenue volumes and favorable product mix.

Gross profit as a percentage of net revenues for our L&M segment increased primarily due to higher revenue volumes and favorable product mix partially offset by unfavorable overhead absorption.

Gross profit as a percentage of net revenues for our E&S segment increased primarily due to improved overhead absorption and lower excess and obsolete charges.

Research and Development

Research and development expenses increased $27 million in 2021, compared to 2020, primarily due to increases of $19 million in compensation-related costs, $3 million in project materials and $3 million in occupancy costs.

Our research and development efforts are primarily focused on developing and improving our instruments, components, subsystems, process control and systems solutions to improve process performance and productivity.

We have thousands of products and our research and development efforts primarily consist of a large number of projects related to these products, none of which is individually material to us. Current projects typically have durations of 3 to 30 months, depending upon whether the product is an enhancement of existing technology or a new product. Our products have continuously advanced as we strive to meet our customers’ evolving needs. We have developed, and continue to develop, new products to address industry trends, such as the shrinking of integrated circuit critical dimensions and technology inflections, and, in the flat panel display and solar markets, the transition to larger substrate sizes, which require more advanced processing and process control technology, the continuing drive toward more complex and accurate components and devices within the handset and tablet market, the transition to 5G for both devices and infrastructure, supporting the growth in units and via counts of the High Density Interconnect PCB drilling market, and the industry transition to electric cars in the automotive market. In addition, we have developed, and continue to develop, products that support the migration to new classes of materials, ultra-thin layers, and 3D structures that are used in small geometry manufacturing. Research and development expenses consist primarily of salaries and related expenses for personnel engaged in research and development, fees paid to consultants, material costs for prototypes and other expenses related to the design, development, testing and enhancement of our products.

We believe that the continued investment in research and development and ongoing development of new products are essential to the expansion of our markets. We expect to continue to make significant investment in research and development activities. We are subject to risks from products not being developed in a timely manner, as well as from rapidly changing customer requirements and competitive threats from other companies and technologies. Our success primarily depends on our products being designed into new generations of equipment for the semiconductor industry and advanced technology markets. We develop products that are technologically advanced so that they are positioned to be chosen for use in each successive generation of semiconductor capital equipment and advanced markets applications. If our products are not chosen to be designed into our customers’ products, our net revenues may be reduced during the lifespan of those products.

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Selling, General and Administrative

Selling, general and administrative expenses increased $32 million during 2021, compared to 2020, primarily due to increases of $26 million in compensation-related costs, $7 million in commissions and $3 million in information technology costs, partially offset by a decrease of $4 million in professional fees.

Acquisition and Integration Costs

Acquisition and integration costs incurred during 2021 related to consulting and professional fees in connection with our recently completed acquisition of Photon Control, our pending acquisition of Atotech and our proposed acquisition of Coherent, Inc. Acquisition and integration costs during 2020 consisted of integration costs related to the acquisition of ESI, consisting primarily of bonus and stock-based compensation for certain ESI executives assisting in the integration process and information technology related costs.

Restructuring and other

Restructuring and other costs incurred in 2021 primarily related to duplicate facility costs attributed to entering into new leases, severance costs due to a global cost saving initiative, severance costs relating to the pending closure of two facilities in Europe and the movement of certain product manufacturing to low cost regions.

Restructuring and other costs in 2020 primarily consisted of duplicate facility costs attributed to entering into new facility leases, costs related to the exit of certain product groups and costs related to the pending closure of a facility in Europe. Such costs were offset by an insurance reimbursement related to a legal settlement.

Amortization of Intangible Assets

Amortization of intangible assets were consistent in 2021 compared to 2020.  New amortization costs in 2021 from our acquisition of Photon Control in July 2021 were offset by the decrease of certain intangible assets in our L&M segment that became fully amortized.

Interest Expense, Net

Interest expense, net, decreased by $3 million in 2021, compared to 2020, primarily due to lower interest expense as a result of lower interest rates and lower average debt balances as a result of principal payments made.

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Other Expense, Net

Other expense, net, for 2021 and 2020 primarily related to changes in foreign exchange rates.

Provision for Income Taxes

Our effective tax rates for 2021 and 2020 were 17.1% and 17.2%, respectively. Our effective tax rates were lower than the U.S. statutory tax rate, mainly due to the geographic mix of income earned by our international subsidiaries being taxed at rates lower than the U.S. statutory tax rate, the deduction for foreign derived intangible income and research credits offset by the tax effects of non-deductible executive compensation and the global intangible low taxed income inclusion.

As of December 31, 2021, the total gross unrecognized tax benefits, which excludes interest and penalties, was $43 million. As of December 31, 2020, the total gross unrecognized tax benefits, which excludes interest and penalties, was $47 million. The net decrease was primarily attributable to the release of a reserve related to federal research tax credits, partially offset by an addition of a reserve related to foreign withholding taxes.

We accrue interest and, if applicable, penalties for any uncertain tax positions. Interest and penalties are classified as a component of income tax expense. As of December 31, 2021 and 2020, we accrued interest on unrecognized tax benefits of approximately $1 million and $1 million, respectively.

Over the next 12 months, it is reasonably possible that we may recognize approximately $4 million of previously net unrecognized tax benefits, excluding interest and penalties, related to various U.S. federal, state and foreign tax positions primarily due to the expiration of statutes of limitations.

We are subject to examination by U.S. federal, state and foreign tax authorities. The U.S. federal statute of limitations remains open for tax years 2018 through the present. The statute of limitations for our tax filings in other jurisdictions varies between fiscal years 2015 through present. We also have certain federal credit carryforwards and state tax loss and credit carryforwards that are open to examination for tax years 2002 through the present. In addition, the 2017 transition tax remains open for examination.

In 2021, we recorded a net benefit to income tax expense of $4 million, excluding interest and penalties, due to reserve releases related to the expiration of certain statutes of limitations for previously open tax years. In 2020, we recorded a net benefit to income tax expense of $1 million, excluding interest and penalties, due to reserve releases related to the expiration of certain statutes of limitations for previously open tax years and the effective settlement of an Internal Revenue Service audit.

Our future effective tax rate depends on various factors, including the impact of tax legislation, further interpretations and guidance from U.S. federal and state governments on the impact of proposed regulations issued by the IRS, as well as the geographic composition of our pre-tax income and changes in income tax reserves for unrecognized tax benefits. We monitor these factors and timely adjust our estimates of the effective tax rate accordingly. We expect the geographic mix of pre-tax income will continue to have a favorable impact on our effective tax rate. However, the geographic mix of pre-tax income can change based on multiple factors, resulting in changes to the effective tax rate in future periods. While we believe we have adequately provided for all tax positions, amounts asserted by taxing authorities could materially differ from our accrued positions as a result of uncertain and complex application of tax law and regulations. Additionally, the recognition and measurement of certain tax benefits include estimates and judgment by management. Accordingly, we could record additional provisions or benefits for U.S. federal, state, and foreign tax matters in future periods as new information becomes available. On March 11, 2021, President Biden signed into law the American Rescue Plan Act of 2021 (“ARPA”). ARPA contains numerous income tax provisions, among other tax and non-tax provisions, to provide COVID-19 pandemic relief. We evaluated the ARPA legislation in relation to income taxes and it did not have a material impact on our financial statements in

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2021. The ARPA income tax provisions that are effective in future years are being evaluated and we have not yet determined the impact on our consolidated financial statements.

Liquidity and Capital Resources

Cash, cash equivalents and short-term marketable investments totaled $1 billion at December 31, 2021, an increase of $207 million compared to $836 million at December 31, 2020. The primary driver in our current and anticipated future cash flows is and will continue to be cash generated from operations, consisting primarily of our net income, excluding non-cash charges and changes in operating assets and liabilities.

Our total cash and cash equivalents and short-term marketable investments at December 31, 2021 consisted of $619 million held in the United States and $419 million held by our foreign subsidiaries. We believe that our current cash and investments position and available borrowing capacity, together with the cash anticipated to be generated from our operations, will be sufficient to satisfy our estimated working capital, planned capital expenditure requirements, and any future cash dividends declared by our Board of Directors or share repurchases through at least the next 12 months and the foreseeable future.

In periods when our sales are growing, higher sales to customers will result in increased trade receivables, and inventories will generally increase as we build products for future sales. This may result in lower cash generated from operations. Conversely, in periods when our sales are declining, our trade accounts receivable and inventory balances will generally decrease, resulting in increased cash from operations.

Net cash provided by operating activities was $639 million for 2021 and resulted from net income of $551 million, which included non-cash net charges of $160 million offset by an increase in working capital of $72 million. The increase in working capital consisted of an increase in inventories of $92 million and an increase in trade accounts receivable of $53 million, both of which were the result of increased business levels in 2021, offset by an increase in accounts payable of $56 million from increased business levels and an increase in current and non-current accrued compensation of $17 million.

Net cash provided by operating activities was $513 million for 2020 and resulted from net income of $350 million, which included non-cash net charges of $152 million and a decrease in working capital of $11 million. The decrease in working capital consisted of a decrease in other current and non-current assets of $41 million, primarily from the collection of income tax receivables, an increase in income taxes payable of $22 million, an increase in accounts payable of $21 million, an increase in current and non-current accrued compensation of $19 million, primarily due to higher variable compensation, and an increase in other current and non-current liabilities of $5 million, offset by an increase in inventories of $52 million and an increase in trade accounts receivable of $45 million, both of which were the result of increased business levels in 2020.

Net cash used in investing activities was $205 million for 2021, reflecting the purchase of Photon Control for $268 million, net of cash and cash equivalents acquired, and purchases of property, plant and equipment of $87 million, primarily for production related equipment, offset by the net sales of short-term investments of $150 million. Net cash used in investing activities was $202 million for 2020, reflecting net purchases of short-term investments of $117 million and purchases of property, plant and equipment of $85 million, which included the buildout of three newly leased facilities in 2020.

Net cash used in financing activities was $65 million for 2021 and was primarily due to dividend payments made to holders of our common stock of $48 million and net payments of short and long-term borrowings of $14 million.

Net cash used in financing activities was $121 million for 2020 and was primarily due to a repayment of our Term Loan Facility of $59 million, dividend payments made to holders of our common stock of $44 million and net payments related to tax payments for employee stock awards of $20 million, offset by net proceeds from short-term borrowings of $2 million.

For the year ended December 31, 2021, we paid cash dividends of $48 million in the aggregate or $0.86 per share. For the year ended December 31, 2020, we paid cash dividends of $44 million in the aggregate or $0.80 per share. Future dividend declarations, if any, as well as the record and payment dates for such dividends, are subject to the final determination of our Board of Directors. Holders of our common stock are entitled to receive dividends when and if they are declared by our Board of Directors. Under the terms of our Term Loan Facility and our ABL Facility, as defined and described further below, we may be restricted from paying dividends under certain circumstances.

On February 7, 2022, our Board of Directors declared a quarterly cash dividend of $0.22 per share to be paid on March 11, 2022 to shareholders of record as of February 28, 2022.

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Atotech Acquisition

On July 1, 2021, we entered into an Implementation Agreement to acquire Atotech, a leading process chemicals technology company and a market leader in advanced electroplating solutions. Pursuant to the Implementation Agreement, we agreed to pay $16.20 per share in cash and 0.0552 of a share of our common stock for each outstanding common share of Atotech. At the time of the announcement of the acquisition, the total value of the aggregate cash and stock consideration was approximately $5.1 billion. The final value of the consideration will be determined at the time of the closing of the acquisition, which is expected to occur in the first quarter of 2022, subject to the satisfaction of certain closing conditions, including receipt of regulatory approval from China and approval by the Royal Court of Jersey. Our obligations to complete the acquisition are not subject to any financing condition. Additional information regarding the funding of the acquisition, the New Term Loan Facility, the New Revolving Credit Facility, and the refinancing of the Term Loan Facility and ABL Facility, is discussed under “Recent Events” above.

Senior Secured Term Loan Credit Facility

In connection with the completion of the acquisition of Newport Corporation (“Newport”) in 2016 (the “Newport Merger”), we entered into a term loan credit agreement (as amended, the “Term Loan Credit Agreement”) with Barclays Bank PLC, as administrative agent and collateral agent, and the lenders from time to time party thereto, which provided a senior secured term loan credit facility (the “Term Loan Facility”) in the original principal amount of $780.0 million. We have entered into seven amendments to the Term Loan Credit Agreement since 2016, including most recently the May Term Loan Amendment (as defined below). The Term Loan Facility is subject to increase at our option and subject to receipt of lender commitments in accordance with the Term Loan Credit Agreement. The maturity date of the Term Loan Facility is February 2, 2026. As of December 31, 2021, borrowings under the Term Loan Facility​​​​​​​ bear interest per annum at one of the following rates selected by us: (a) a base rate determined by reference to the highest of (1) the federal funds effective rate plus 0.50%, (2) the “prime rate” quoted in The Wall Street Journal, (3) a London Interbank Offered Rate (“LIBOR”) rate determined by reference to the costs of funds for U.S. dollar deposits for an interest period of one month adjusted for certain additional costs, plus 1.00%, and (4) a floor of 1.00%, plus, in each case, an applicable margin of 0.75%; or (b) a LIBOR rate determined by reference to the costs of funds for U.S. dollar deposits for the interest period relevant to such borrowing adjusted for certain additional costs, subject to a LIBOR rate floor of 0.0%, plus an applicable margin of 1.75%. We have elected the interest rate as described in clause (b) of the foregoing sentence. The Term Loan Credit Agreement provides that, unless an alternate rate of interest is agreed, all loans will be determined by reference to the base rate if the LIBOR rate cannot be ascertained, if regulators impose material restrictions on the authority of a lender to make LIBOR rate loans, or for other reasons.

In May 2021, we entered into an amendment (the “May Term Loan Amendment”) to the Term Loan Credit Agreement. The May Term Loan Amendment amends the Term Loan Facility to, among other things, (i) increase our ability to incur additional incremental debt facilities to (x) the greater of (1) $600 million and (2) 100% of consolidated EBITDA, plus (y) an amount equal to the sum of all voluntary prepayments of term loans under the Term Loan Facility, plus (z) an additional unlimited amount subject to pro forma compliance with a secured leverage ratio test of 3.25:1.00, and (ii) increase our flexibility under certain debt, lien, investment, restricted payment and disposition baskets. The fees incurred, including certain customary lender consent fees, in connection with the May Term Loan Amendment were immaterial.

We are required to make scheduled quarterly amortization payments each equal to 0.25% of the original principal amount of the Term Loan Facility. As of December 31, 2021, the remaining balance of deferred finance fees, original issue discount and repricing fees related to the term loans under the Term Loan Facility was $8 million.

As of December 31, 2021, after giving effect to all amendments and repayments prior to such date, the outstanding principal amount of the Term Loan Facility was $824 million, and the interest rate was 1.8%.

Under the Term Loan Credit Agreement, we are required to prepay outstanding term loans, subject to certain exceptions, with portions of our annual excess cash flow as well as with the net cash proceeds of certain of our asset sales, certain casualty and condemnation events and the incurrence or issuance of certain debt.

All obligations under the Term Loan Facility are guaranteed by certain of our domestic subsidiaries and are secured by substantially all of our assets and the assets of such subsidiaries, subject to certain exceptions and exclusions.

The Term Loan Credit Agreement contains customary representations and warranties, affirmative and negative covenants and provisions relating to events of default. If an event of default occurs, the lenders under the Term Loan Facility will be entitled to take various actions, including the acceleration of amounts due under the Term Loan Facility and all actions

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generally permitted to be taken by a secured creditor. At December 31, 2021, we were in compliance with all covenants under the Term Loan Credit Agreement.

Senior Secured Asset-Based Revolving Credit Facility

In February 2019, in connection with the completion of the ESI Merger, we entered into an asset-based revolving credit agreement with Barclays Bank PLC, as administrative agent and collateral agent, the other borrowers from time to time party thereto, and the lenders and letters of credit issuers from time to time party thereto (the “ABL Credit Agreement”), that provides a senior secured asset-based revolving credit facility of up to $100 million, subject to a borrowing base limitation (the “ABL Facility”). We have entered into two amendments to the ABL Credit Agreement since 2019.  As of December 31, 2021, after giving effect to all amendments, the borrowing base for the ABL Facility at any time equals the sum of: (a) 85% of certain eligible accounts; plus (b) prior to certain notice and field examination and appraisal requirements, the lesser of (i) 20% of net book value of eligible inventory in the United States and (ii) 30% of the borrowing base, and after the satisfaction of such requirements, the lesser of (i) the lesser of (A) 65% of the lower of cost or market value of certain eligible inventory and (B) 85% of the net orderly liquidation value of certain eligible inventory and (ii) 30% of the borrowing base; minus (c) reserves established by the administrative agent, in each case, subject to additional limitations and examination requirements for eligible accounts and eligible inventory acquired in an acquisition after February 1, 2019. The ABL Facility includes borrowing capacity in the form of letters of credit up to $25 million.  We have not borrowed against the ABL Facility to date.

As of December 31, 2021, any borrowings under the ABL Facility bear interest at a rate per annum equal to, at our option, any of the following, plus, in each case, an applicable margin: (a) a base rate determined by reference to the highest of (1) the federal funds effective rate plus 0.50%, (2) the “prime rate” quoted in The Wall Street Journal, (3) a LIBOR rate determined by reference to the costs of funds for U.S. dollar deposits for an interest period of one month adjusted for certain additional costs, plus 1.00% and (4) a floor of 0.00%, plus, in each case, an applicable margin ranging from 0.25% to 0.50%; and (b) a LIBOR rate determined by reference to the costs of funds for U.S. dollar deposits for the interest period relevant to such borrowing adjusted for certain additional costs, with a floor of 0.00%, plus, in each case, an applicable margin ranging from 1.25% to 1.50%.  The applicable margin for borrowings thereunder is subject to upward or downward adjustment each fiscal quarter, based on the average historical excess availability during the preceding quarter.

In addition to paying interest on any outstanding principal under the ABL Facility, we are required to pay a commitment fee in respect of the unutilized commitments thereunder equal to 0.25% per annum. We must also pay customary letter of credit fees and agency fees.

Under the ABL Facility, we are required to prepay amounts outstanding under the ABL Facility (1) if amounts outstanding under the ABL Facility exceed the lesser of (a) the commitment amount and (b) the borrowing base, in an amount required to reduce such shortfall, (2) if amounts outstanding under the ABL Facility in any currency other than U.S. dollars exceed the sublimit for such currency, in an amount required to reduce such shortfall, and (3) during any period in which we have excess availability less than the greater of (a) 10.0% of the lesser of (x) the commitment amount and (y) the borrowing base (the “Line Cap”) and (b) $9 million for 3 consecutive business days, until the time when we have excess availability equal to or greater than the greater of (A) 10.0% of the Line Cap and (B) $9 million for 30 consecutive days, or during the continuance of an event of default, with immediately available funds in our blocked accounts.

There is no scheduled amortization under the ABL Facility. Any principal amount outstanding under the ABL Facility is due and payable in full on the fifth anniversary of the closing date, subject to a springing maturity in the event that term loans under the Term Loan Facility in an aggregate amount of at least $100 million have an earlier maturity date than the ABL Facility.

All obligations under the ABL Facility are guaranteed by certain of our domestic subsidiaries and are secured by substantially all of our assets and the assets of such subsidiaries, subject to certain exceptions and exclusions.

From the time when we have excess availability less than the greater of (a) 10.0% of the Line Cap and (b) $9 million until the time when we have excess availability equal to or greater than the greater of (a) 10.0% of the Line Cap and (b) $9 million for 30 consecutive days, or during the continuance of an event of default, the ABL Credit Agreement requires that we maintain a fixed charge coverage ratio, tested on the last day of each fiscal quarter, of at least 1.0 to 1.0.

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The ABL Credit Agreement also contains customary representations and warranties, affirmative covenants and provisions relating to events of default. If an event of default occurs, the lenders under the ABL Facility will be entitled to take various actions, including the acceleration of amounts due under the ABL Facility and all actions permitted to be taken by a secured creditor.

Lines of Credit and Short-Term Borrowing Arrangements

Our Japanese subsidiaries have lines of credit and a financing facility with various financial institutions, many of which generally expire and are renewed at three-month intervals with the remaining having no expiration date. The lines of credit and financing facility provided for aggregate borrowings as of December 31, 2021 of up to an equivalent of $29 million U.S. dollars. There were no borrowings outstanding under these arrangements at December 31, 2021. Total borrowings outstanding under these arrangements were $6 million at December 31, 2020.

Contractual Obligations

As of December 31, 2021, we are a party to purchase commitments for certain inventory components and other equipment and services used in our normal operations totaling approximately $389 million. The majority of these purchase commitments covered by these arrangements are for periods of less than one year.

In addition, we have various operating leases for real estate and non-real estate items. The non-real estate leases are mainly comprised of automobiles but also include office equipment and other lower-valued items. Future payments related to operating leases are as follows:

Contractual maturities of our debt obligations as of December 31, 2021 are as follows:

We have a number of defined benefit pension plans, which cover substantially all of our full-time employees in France, Germany, Israel, Japan and Taiwan. In addition, we have certain pension assets and liabilities relating to our former employees in the United Kingdom. As of December 31, 2021, our estimated benefit payments over the next 10 years amount to $15 million. The majority of the benefit payments covered by these arrangements occurs after 2026.

Derivatives

We enter into derivative instruments for risk management purposes only, including derivatives designated as hedging instruments and those utilized as economic hedges. We operate internationally, and in the normal course of business, are exposed to fluctuations in interest rates and foreign exchange rates. These fluctuations can increase the costs of financing, investing and operating the business. We have used derivative instruments, such as foreign exchange forward contracts and options, to manage certain foreign currency exposure, and interest rate swaps to manage interest rate exposure.

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By nature, all financial instruments involve market and credit risks. We enter into derivative instruments with major investment grade financial institutions and no collateral is required. We have policies to monitor the credit risk of these counterparties. While there can be no assurance, we do not anticipate any material non-performance by any of these counterparties.

Interest Rate Swap Agreements

We entered into various interest rate swap agreements as described further in Note 9 to the Notes to Consolidated Financial Statements that exchange the variable LIBOR interest rate to a fixed rate in order to manage the exposure to interest rate fluctuations associated with the variable LIBOR interest rate paid on the outstanding balance of the Term Loan Facility. We expect to enter into interest rate swap agreements in order to manage the exposure to interest rate fluctuations associated with the variable SOFR interest rate of the New Term Loan Facility.

The interest rate swaps are recorded at fair value on the balance sheet and changes in the fair value are recognized in Accumulated Other Comprehensive Income. To the extent that these arrangements are no longer an effective hedge, any ineffectiveness measured in the hedging relationships is recorded immediately in earnings in the period it occurs. The fair value of the interest rate swaps is classified in other assets or non-current liabilities, accordingly, in the consolidated balance sheet.

Currency Option Agreements

In conjunction with financing the proposed acquisition of Atotech, we expect to issue EUR 500 million term loan debt. At the expected close, a portion of those proceeds will settle Atotech’s existing EUR 200 million term loan, and the EUR 300 million balance will be converted into USD in support of the USD purchase price. We purchased foreign currency option contracts to fix the conversion of EUR 300 million into USD as noted below:

The currency swaps are recorded at fair value on the balance sheet and changes in the fair value are recognized immediately in earnings. The fair value asset is classified in other current assets in the consolidated balance sheet. We recorded an unrealized gain of $3 million in 2021, net of premiums, which is included in other expense, net.

In conjunction with the Photon Control Acquisition, we entered into a foreign currency contract to hedge the Canadian dollar purchase price. In 2021, we recorded a fair value realized loss of $10 million, which is included in other expense, net.

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Foreign Exchange Contracts

We hedge a portion of our forecasted foreign currency denominated intercompany sales of inventory, over a maximum period of eighteen months, using foreign exchange forward contracts accounted for as cash-flow hedges related to British, Euro, Japanese, South Korean and Taiwanese currencies. To the extent these derivatives are effective in offsetting the variability of the hedged cash flows, and otherwise meet the hedge accounting criteria, changes in the derivatives’ fair value are not included in current earnings but are included in accumulated other comprehensive income in stockholders’ equity. These changes in fair value will subsequently be reclassified into earnings, as applicable, when the forecasted transaction occurs. To the extent that a previously designated hedging transaction is no longer an effective hedge, any ineffectiveness measured in the hedging relationship is recorded immediately in earnings in the period it occurs. The cash flows resulting from forward exchange contracts are classified in the consolidated statements of cash flows as part of cash flows from operating activities. We do not enter into derivative instruments for trading or speculative purposes.

We also enter into foreign exchange forward contracts to hedge certain balance sheet amounts. To the extent the hedge accounting criteria is not met, the related foreign currency forward contracts are considered as economic hedges and changes in the fair value of these contracts are recorded immediately in earnings in the period in which they occur. These include hedges that are used to reduce exchange rate risks arising from the change in fair value of certain foreign currency-denominated assets and liabilities (i.e., payables, receivables) and other economic hedges where the hedge accounting criteria were not met.

We had foreign exchange forward contracts with notional amounts totaling $240 million outstanding at December 31, 2021, of which $108 million was outstanding to exchange South Korean won to U.S. dollars and $60 million was outstanding to exchange Japanese yen to U.S. dollars. We had forward exchange contracts with notional amounts totaling $176 million outstanding at December 31, 2020, of which $62 million was outstanding to exchange South Korean won to U.S. dollars and $62 million was outstanding to exchange Japanese yen to U.S. dollars.

As of December 31, 2021, the unrealized loss that will be reclassified from accumulated other comprehensive income to earnings over the next twelve months is immaterial. Gains and losses on forward exchange contracts that qualify for hedge accounting are classified in cost of products in 2021 and 2020, and totaled a (loss) gain of $(2) million and $2 million, respectively. There were no ineffective portions of the derivatives recorded in 2021 and 2020.

We hedge certain intercompany accounts receivable and intercompany loans with forward exchange contracts. Typically, as these derivatives hedge existing amounts that are denominated in foreign currencies, the derivatives do not qualify for hedge accounting. Realized and unrealized gains and losses on forward exchange contracts that do not qualify for hedge accounting are recognized immediately in earnings. The net foreign exchange gains or losses on these derivatives were immaterial in each of 2021 and 2020. Foreign currency gains or losses are classified in other expense, net. The cash flows resulting from forward exchange contracts are classified in our consolidated statements of cash flows as part of cash flows from operating activities. We do not hold or issue derivative financial instruments for trading purposes.

Recently Issued Accounting Pronouncements

In March 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-04, “Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting.” This standard provides temporary optional expedients and exceptions to accounting guidance on contract modifications and hedge accounting to ease entities’ financial reporting burdens as the market transitions from the London Interbank Offered Rate (“LIBOR”) and other interbank offered rates to alternative reference rates. The standard was effective upon issuance and generally can be applied through December 31, 2022. In January 2021, the FASB issued ASU 2021-01, “Reference Rate Reform (Topic 848): Scope.” The amendments in this update clarify that certain optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting apply to derivative instruments that use an interest rate for margining, discounting, or contract price alignment that is modified as a result of reference rate reform. Amendments in this update to the expedients and exceptions in Topic 848 capture the incremental consequences of the scope clarification and tailor the existing guidance to derivative instruments affected by the discounting transition. The amendments in this update do not apply to contract modifications made after December 31, 2022, new hedging relationships entered into after December 31, 2022, and existing hedging relationships evaluated for effectiveness in periods after December 31, 2022, except for hedging relationships existing as of December 31, 2022, that apply certain optional expedients in which the accounting effects are recorded through the end of the hedging relationship (including periods after December 31, 2022). The adoption of the requirements of these standards has not resulted in a material impact on our financial position, results of operations and cash flows, but the adoption of the requirements may impact us in the future.

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