MONOLITHIC POWER SYSTEMS, INC. (MPWR) FY 2022 MD&A

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

The following discussion should be read in conjunction with the consolidated financial statements and related notes which appear under Item 8 in this Annual Report on Form 10-K. This discussion and analysis contain, in addition to historical information, forward-looking statements that include risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under “Part I, Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K.

Discussions of 2020 results and year-to-year comparisons between 2021 and 2020 that are omitted in this Annual Report on Form 10-K can be found in “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, 2021, filed with the SEC on February 25, 2022.

Overview

We are a fabless company with a global footprint that provides high-performance, semiconductor-based power electronic solutions. Incorporated in 1997, our three core strengths include deep system-level knowledge, strong semiconductor expertise, and innovative proprietary technologies in the areas of semiconductor processes, system integration, and packaging. These combined advantages enable us to deliver reliable, compact, and monolithic solutions found in storage and computing, enterprise data, automotive, industrial, communications and consumer applications. Our mission is to reduce energy and material consumption to improve all aspects of quality of life. We believe that we differentiate ourselves by offering solutions that are more highly integrated, smaller in size, more energy-efficient, more accurate with respect to performance specifications and, consequently, more cost-effective than many competing solutions. We plan to continue to introduce new products within our existing product families, as well as in new innovative product categories.

We operate in the cyclical semiconductor industry. We are not immune from industry downturns, but we have targeted product and market areas that we believe have the ability to offer above average industry performance over the long term. Historically, our revenue has generally been higher in the second half of the year than in the first half although various factors, such as market conditions and the timing of key product introductions, could impact this trend.

We work with third parties to manufacture and assemble our ICs. This has enabled us to limit our capital expenditures and fixed costs, while focusing our engineering and design resources on our core strengths.

Following the introduction of a product, our sales cycle generally takes a number of quarters after we receive an initial customer order for a new product to ramp up. Typical supply chain lead times for orders are generally 16 to 26 weeks. These factors, combined with the fact that our customers can cancel or reschedule orders without significant penalty to the customer, make the forecasting of our orders and revenue difficult.

We derive most of our revenue from sales through distribution arrangements and direct sales to customers in Asia, where our products are incorporated into end-user products. Our revenue from direct or indirect sales to customers in Asia was 86%, 90% and 91% for the years ended December 31, 2022, 2021 and 2020, respectively. We derive a majority of our revenue from the sales of our DC to DC converter products which serve the storage and computing, enterprise data, automotive, industrial, communications and consumer markets. We believe our ability to achieve revenue growth will depend, in part, on our ability to develop new products, enter new market segments, gain market share, manage litigation risk, diversify our customer base and continue to secure manufacturing capacity.

Impact of COVID-19 on Our Business

The COVID-19 pandemic has had, and continues to have, a significant impact around the world. Our primary focus is to continue to execute our business plan and mitigate the effect of the COVID-19 pandemic on our financial position and operations, while actively taking all necessary precautions to ensure the safety of our employees, our suppliers and our customers. The pandemic did not have a material adverse impact on our overall operating results or business operations for the year ended December 31, 2022.

In 2022, China has continued to experience outbreaks, specifically in Shanghai and Chengdu where we have business operations and where many of our customers and suppliers are located. Local governments have implemented, and may continue to implement, strict measures including quarantines, shutdowns and other business restrictions, which have resulted in logistics challenges throughout China. Although these strict measures and the disruptions, as a result thereof, did not have a material adverse impact on our operations in 2022, we will continue to monitor and evaluate future developments. However, we cannot reasonably estimate the potential effect of these measures on the global economy, the semiconductor industry and our business.

We have worked, and are continuing to actively work, with our stakeholders, including customers, suppliers and employees, to address the impact of the pandemic. We will continue to monitor the situation, to assess further possible implications to our business, supply chain and customers, and to take actions in an effort to mitigate adverse consequences to the extent feasible. A prolonged economic slowdown as a result of the pandemic, or otherwise, could materially and adversely impact our business, results of operations and financial condition for 2023 and beyond.

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Russia-Ukraine Conflict

As the Russia-Ukraine conflict continues to evolve, we are closely monitoring the impact of future developments on our business, supply chain, employees, customers and other business partners. Our total revenue in Russia has historically not been material and we have stopped shipping to customers in Russia. All accounts receivable balances from our customers in Russia have been paid.

Macroeconomic Conditions and Recent Regulations

During 2022, the semiconductor industry faced a number of macro-economic challenges including the impact of supply chain capacity constraints, wide swings in customer demand, rising inflation, increased interest rates, and fluctuations in currency rates. We remain cautious in light of changing macroeconomic conditions and will continue to monitor potential impact on our operations. The implications of macroeconomic events on our business, results of operations and overall financial position remain uncertain.

There also have been recent changes to export control laws, trade regulations and other trade requirements. As of December 31, 2022 and through the date we filed this Annual Report, there have been a number of additional trade restrictions introduced. To date, those restrictions have had an immaterial impact on our revenue and operations. We will continue to monitor any changes to export control laws, trade regulations and other trade requirements and are committed to complying with all applicable trade laws, regulations and other requirements.

Cybersecurity Risk Management

We are committed to protecting our IT assets, including computers, systems, corporate networks and sensitive data, from unauthorized access or attack. We have established an internal global IT policy handbook as well as IT security management control procedures designed to:

We require all new employees to attend an IT security training orientation. In addition, on a regular basis, our IT team updates training materials related to our policies and procedures and shares news and articles related to cybersecurity awareness, both of which are stored on our intranet and available to all employees. We also currently maintain an insurance policy that provides certain coverage for losses we incur due to data breaches and other cybersecurity incidents.

Our IT Steering Committee, which consists of our senior management and IT team, meets on a regular basis to review initiatives and projects to improve IT security, as well as resources and budgets for our cybersecurity compliance and education efforts. In 2021, we completed the ISO 27001 certification, a globally recognized information security standard.

Our Audit Committee of the Board of Directors, which consists of three independent members, is responsible for the oversight of our cybersecurity risk program. At least quarterly, the Audit Committee reviews reports and updates from our Chief Financial Officer and IT senior management about major risk exposures, their potential impact on our business operations, and management’s strategies to assess, monitor and mitigate those risks. The Audit Committee also provides updates of their oversight and findings to the Board of Directors.

We believe we have adequate resources and sufficient policies, procedures and oversight in place to identify and manage our IT security risks to our business operations. To date, we do not believe we have experienced any material information security breaches and have not incurred significant operating expenses related to information security breaches.

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Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis, including those related to revenue recognition, stock-based compensation, inventories, income taxes and contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making the judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments used in the preparation of our financial statements are, by their nature, uncertain and unpredictable, and depend upon, among other things, many factors outside of our control, including demand for our products, economic conditions and other current and future events, such as macroeconomic factors, including the impact of the COVID-19 pandemic, the global economic downturn and the Russia-Ukraine conflict. Actual results could differ from these estimates and assumptions, and any such differences may be material to our consolidated financial statements. See Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for a summary of significant accounting policies and the effect on our financial statements.

As of the date of issuance of these consolidated financial statements, we are not aware of any specific event or circumstance that would require our management to update the significant estimates and assumptions used in the preparation of the consolidated financial statements. As new events continue to evolve and additional information becomes available, any changes to these estimates and assumptions will be recognized in the consolidated financial statements as soon as they become known.

We believe the following critical accounting policies reflect our more significant judgments used in the preparation of our consolidated financial statements.

Revenue Recognition

We account for price adjustments and stock rotation rights as variable consideration that reduces the transaction price, and recognize that reduction in the same period the associated revenue is recognized. Four U.S.-based distributors have price adjustment rights when they sell our products to their end customers at a price that is lower than the distribution price invoiced by us. When we receive claims from the distributors that products have been sold to the end customers at the lower price, we issue the distributors credit memos for the price adjustments. We estimate the price adjustments using the expected value method based on an analysis of historical claims, at both the distributor and product level, as well as an assessment of any known trends of product sales mix.

Certain distributors have limited stock rotation rights that permit the return of a small percentage of the previous six months’ purchases in accordance with the contract terms. We estimate the stock rotation returns using the expected value method based on an analysis of historical returns, and the current level of inventory in the distribution channel.

Overall, our estimates of adjustments to contract price due to variable consideration have been materially consistent with actual results; however, these estimates are subject to management’s judgment and actual provisions could be different from our estimates and current provisions, resulting in future adjustments to our revenue and operating results.

Inventory Valuation

Inventories are stated at the lower of standard cost (which approximates actual cost determined on a first-in first-out basis) and estimated net realizable value. We write down excess and obsolete inventories based on their age and forecasted demand, which includes estimates taking into consideration our revenue forecast, outlook on market and economic conditions, technology changes, new product introductions and changes in strategic direction. If actual demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Conversely, if actual demand or market conditions are more favorable, inventories may be sold that were previously written down.

Accounting for Income Taxes

Our calculation of current and deferred tax assets and liabilities is based on certain estimates and judgments and involves dealing with uncertainties in the application of complex tax laws. Our estimates of current and deferred tax assets and liabilities may change based, in part, on added certainty, finality or uncertainty to an anticipated outcome, changes in accounting or tax laws in the U.S. or foreign jurisdictions where we operate, or changes in other facts or circumstances. In addition, we recognize liabilities for potential U.S. and foreign income tax for uncertain income tax positions taken on our tax returns if it has less than a 50% likelihood of being sustained. If we determine that payment of these amounts is unnecessary or if the recorded tax liability is less than our current assessment, we may be required to recognize an income tax benefit or additional income tax expense in our financial statements in the period such determination is made.

As of December 31, 2022 and 2021, we had a valuation allowance of $20.3 million and $19.5 million, respectively, attributable to management’s determination that it is more likely than not that certain deferred tax assets will not be fully realized. In the event we determine that it is more likely than not that we would be able to realize the deferred tax assets in the future in excess of our net recorded amount, an adjustment to the valuation allowance for the deferred tax assets would increase income in the period such determination was made. Likewise, should it be determined that additional amounts of the net deferred tax assets will not be realized in the future, an adjustment to increase the deferred tax assets valuation allowance will be charged to income in the period such determination is made.

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Contingencies

We record a contingent liability related to pending legal and regulatory proceedings when it is probable that a loss has been incurred and the amount is reasonably estimable. Based on the facts and circumstances in each matter, the determination of such liability requires significant judgment. In determining the amount of a contingent loss, we take into account advice received from experts for each specific matter regarding the status of legal proceedings, settlement negotiations, prior case history and other factors. Should the judgments and estimates made by management need to be adjusted as additional information becomes available, we may need to record additional contingent losses that could materially and adversely impact our results of operations. Alternatively, if the judgments and estimates made by management are adjusted, for example, if a particular contingent loss does not occur, the contingent loss recorded would be reversed which could result in a favorable impact on our results of operations.

Stock-Based Compensation

For equity awards with performance conditions, as well as awards containing both market and performance conditions, we recognize compensation expense when it becomes probable that the performance goals will be achieved. Management performs the probability assessment on a quarterly basis by reviewing external factors, such as macroeconomic conditions and the analog industry revenue forecasts, and internal factors, such as our business and operational objectives and revenue forecasts. Changes in the probability assessment of achievement of the performance conditions are accounted for in the period of change by recording a cumulative catch-up adjustment as if the new estimate had been applied since the service inception date. If the projected achievement was revised upward or if the actual results were higher than the projected achievement, additional compensation expense would be recorded for the awards due to the cumulative catch-up adjustment, which would have an adverse impact on our results of operations. Conversely, if the projected achievement was revised downward or if the actual results were lower than the projected achievement, previously accrued compensation expense would be reversed for the awards, which would have a favorable impact on our results of operations. As a result, our stock-based compensation expense is subject to volatility and may fluctuate significantly each quarter due to changes in our probability assessment of achievement of the performance conditions or actual results being different from projections made by management.

Recent Accounting Pronouncements

See Note 1 of the Notes to Consolidated Financial Statements regarding accounting pronouncements not yet adopted as of December 31, 2022.

Results of Operations

The following table summarizes our results of operations:

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Revenue

The following table summarizes our revenue by end market:

Revenue for the year ended December 31, 2022 was $1,794.1 million, an increase of $586.3 million, or 48.5%, from $1,207.8 million for the year ended December 31, 2021. The increase in revenue was primarily due to increases in the average selling prices resulting primarily from the sale of higher value products and increases in shipment volume.

For the year ended December 31, 2022, revenue from the storage and computing market increased $196.7 million, or 76.8%, from the same period in 2021. This increase was primarily driven by strong sales growth for storage applications and enterprise notebooks. Revenue from the enterprise data market increased $135.1 million, or 116.1%, from the same period in 2021. This increase was primarily due to higher sales of our power management solutions for cloud-based CPU and GPU server applications. Revenue from the automotive market increased $95.7 million, or 46.8%, from the same period in 2021. This increase was primarily due to increased sales of our highly integrated applications supporting automated driver assistance systems, digital cockpits and connectivity. Revenue from the industrial market increased $34.4 million, or 18.6%, from the same period in 2021. This increase was primarily due to higher sales in applications for smart meters and industrial automation. Revenue from the communications market increased $87.4 million, or 53.2%, from the same period in 2021. The increase was primarily due to higher sales of products for both 5G and satellite communications infrastructure applications. Revenue from the consumer market increased $37.2 million, or 13.2%, from the same period in 2021. This increase was primarily driven by increased sales for home appliances, gaming consoles and smart TVs.

Cost of Revenue and Gross Margin

Cost of revenue primarily consists of costs incurred to manufacture, assemble and test our products, as well as warranty costs, inventory-related and other overhead costs, and stock-based compensation expenses.

Cost of revenue was $745.6 million, or 41.6% of revenue, for the year ended December 31, 2022, and $522.3 million, or 43.2% of revenue, for the year ended December 31, 2021. The $223.3 million increase in cost of revenue was primarily due to increased shipment volume, product mix, increases in manufacturing overhead costs and increased input cost.

Gross margin was 58.4% for the year ended December 31, 2022, compared with 56.8% for the year ended December 31, 2021. The increase in gross margin was mainly driven by lower warranty expenses as a percentage of revenue and a favorable product mix.

Research and Development (“R&D”)

R&D expenses primarily consist of salary and benefit expenses, bonuses, stock-based compensation and deferred compensation for design and product engineers, expenses related to new product development and supplies, and facility costs.

R&D expenses were $240.2 million, or 13.4% of revenue, for the year ended December 31, 2022, and $190.6 million, or 15.8% of revenue, for the year ended December 31, 2021. The $49.6 million increase in R&D expenses was primarily due to an increase of $40.1 million in cash compensation expenses, which include salary, benefits and bonuses, and an increase of $9.3 million in stock-based compensation expenses, which were mainly associated with performance-based equity awards. The increase was partially offset by a $4.7 million benefit related to changes in the value of deferred compensation plan liabilities. Our R&D headcount was 1,328 employees as of December 31, 2022, compared with 1,087 employees as of December 31, 2021.

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Selling, General and Administrative (“SG&A”)

SG&A expenses primarily include salary and benefit expenses, bonuses, stock-based compensation and deferred compensation for sales, marketing and administrative personnel, sales commissions, travel expenses, facilities costs, and professional service fees.

SG&A expenses were $273.6 million, or 15.2% of revenue, for the year ended December 31, 2022, and $226.2 million, or 18.7% of revenue, for the year ended December 31, 2021. The $47.4 million increase in SG&A expenses was primarily due to an increase of $27.0 million in stock-based compensation expenses, which were mainly associated with performance-based equity awards, and $20.7 million in cash compensation expenses, which include salary, benefits and bonuses. The increase was partially offset by a $7.2 million benefit related to changes in the value of deferred compensation plan liabilities. Our SG&A headcount was 780 employees as of December 31, 2022, compared with 688 employees as of December 31, 2021.

Litigation Expense, Net

Litigation expense was $8.0 million for the year ended December 31, 2022, compared with litigation expense, net, of $6.2 million for the year ended December 31, 2021. The expense for both periods was attributable to litigation activity related to ongoing patent infringement and other matters.

Other Income (Expense), Net

Other expense, net, was $1.8 million for the year ended December 31, 2022, compared with other income, net, of $9.8 million for the year ended December 31, 2021. The increase in other expense was primarily due to an increase of $11.2 million in expense related to changes in the value of deferred compensation plan investments and an increase of $4.4 million in charitable contributions, which was partially offset by an increase of $3.0 million in net interest income.

Income Tax Expense

The income tax expense for the year ended December 31, 2022 was $87.3 million, or 16.6% of pre-tax income. The effective tax rate was lower than the federal statutory rate primarily due to foreign income from our subsidiaries in Bermuda and China being taxed at lower statutory tax rates, and excess tax benefits from stock-based compensation. The decrease in the effective tax rate relative to the federal statutory rate was partially offset by the inclusion of the global intangible low-taxed income (“GILTI”) tax.

The income tax expense for the year ended December 31, 2021 was $30.2 million, or 11.1% of pre-tax income. The effective tax rate was lower than the federal statutory rate primarily due to foreign income from our subsidiaries in Bermuda and China being taxed at lower statutory tax rates. The decrease in the effective tax rate relative to the federal statutory rate was partially offset by the inclusion of the GILTI tax.

The increase in the effective tax rate for the year ended December 31, 2022 compared to the prior period was primarily due to an increase in GILTI inclusion due to the capitalization of research and experimental expenditures under Section 174 of the Internal Revenue Code (the “IRC”) and lower excess tax benefits from stock-based compensation. The increase was partially offset by higher foreign income from our subsidiaries in Bermuda and China taxed at lower statutory tax rates.

In August 2022, the CHIPS Act and the Inflation Reduction Act of 2022 (the “IRA”) were enacted and signed into law, which did not have a material impact on our income tax provisions, results of operations or financial condition for the year ending December 31, 2022. We will continue to monitor any new developments related to the CHIPS Act and the IRA and evaluate their impact on our financial statements.

See Note 11 of the Notes to Consolidated Financial Statements for further discussion.

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Liquidity and Capital Resources

As of December 31, 2022, we had cash and cash equivalents of $288.6 million and short-term investments of $449.3 million, compared with cash and cash equivalents of $189.3 million and short-term investments of $535.8 million as of December 31, 2021. As of December 31, 2022, $253.8 million of cash and cash equivalents and $270.4 million of short-term investments were held by our international subsidiaries. We have and may continue to repatriate cash from our Bermuda subsidiary to fund our expenditures in future periods. We anticipate that earnings from other foreign subsidiaries will continue to be indefinitely reinvested.

Summary of Cash Flows

The following table summarizes our cash flow activities:

For the year ended December 31, 2022, the $73.3 million decrease in cash provided by operating activities compared to the prior period was primarily due to changes in operating assets and liabilities, in particular, inventories and prepaid wafer purchases, partially offset by an increase of $195.6 million in net income and an increase of $37.5 million in stock-based compensation expenses.

For the year ended December 31, 2022, the $366.4 million decrease in cash used in investing activities compared to the prior period was primarily due to a $331.2 million decrease in purchases of short-term investments and a $35.6 million decrease in capital expenditures.

For the year ended December 31, 2022, the $38.6 million increase in cash used in financing activities compared to the prior period was primarily due to a $28.6 million increase in dividend and dividend equivalent payments and a $12.0 million decrease in proceeds from common stock issued under the employee equity incentive plan.

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In the future, in order to strengthen our financial position, respond to adverse developments, changes in our circumstance or unforeseen events or conditions, or fund our growth, we may need to raise additional funds by any one or a combination of the following: issuing equity securities, issuing debt or convertible debt securities, incurring indebtedness secured by our assets, or selling certain product lines and/or portions of our business. There can be no guarantee that we will be able to raise additional funds on terms acceptable to us, or at all.

From time to time, we have engaged in discussions with third parties concerning capital investments and potential acquisitions of product lines, technologies, businesses and companies, and we continue to consider potential investments and acquisition candidates. Any such transactions could involve the issuance of a significant number of new equity securities, assumptions of debt, and/or payment of cash consideration. We may also be required to raise additional funds to complete any such investments or acquisitions, through either the issuance of equity and/or debt securities or incurring indebtedness secured by our assets. If we raise additional funds or acquire businesses or technologies through the issuance of equity securities or convertible debt securities, our existing stockholders may experience significant dilution.

Cash Requirements

Although consequences of economic uncertainty and macroeconomic conditions and other factors could adversely affect our liquidity and capital resources in the future, and cash requirements may fluctuate based on the timing and extent of many factors such as those discussed above, we believe that our balances of cash, cash equivalents and short-term investments of $737.9 million as of December 31, 2022, along with cash generated by ongoing operations, will be sufficient to satisfy our liquidity requirements for the next 12 months and beyond.

Our material cash requirements include the following contractual and other obligations:

Purchase Obligations

Purchase obligations represent our obligations with our suppliers and other parties that require the purchases of goods or services, which primarily consist of wafer and other inventory purchases, assembly and other manufacturing services, construction of manufacturing and R&D facilities, purchases of production and other equipment, and license arrangements.

In May 2022, we entered into a long-term supply agreement in order to secure manufacturing production capacity for silicon wafers over a four-year period. As of December 31, 2022, the Company had made prepayments under this agreement of $170.0 million.

As of December 31, 2022, total estimated future unconditional purchase commitments to all suppliers and other parties were $1.1 billion, of which $455.4 million was short-term.

Transition Tax Liability

The transition tax liability represents the one-time, mandatory deemed repatriation tax imposed on previously deferred foreign earnings under the U.S. Tax Cuts and Jobs Act enacted in December 2017 (“2017 Tax Act”). As permitted by the 2017 Tax Act, we have elected to pay the tax liability in installments on an interest-free basis through 2025. As of December 31, 2022, the remaining liability totaled $14.8 million, of which $3.7 million was short-term.

Operating Leases

Operating lease obligations represent the undiscounted remaining lease payments primarily for our leased facilities and equipment. As of December 31, 2022, these obligations totaled $3.8 million, of which $2.1 million was short-term.

Dividends

We currently have a dividend program approved by our Board of Directors, pursuant to which we intend to pay quarterly cash dividends on our common stock. Based on our historical practice, stockholders of record as of the last business day of the quarter are entitled to receive the quarterly cash dividends when and if declared by the Board of Directors, which are payable to the stockholders in the following month. As of December 31, 2022, accrued dividends totaled $35.3 million. The declaration of any future cash dividends is at the discretion of our Board of Directors and will depend on, among other things, our financial condition, results of operations, capital requirements, business conditions and other factors that our Board of Directors may deem relevant, as well as a determination that cash dividends are in the best interests of our stockholders.

In February 2023, our Board of Directors approved an increase in the quarterly cash dividend from $0.75 per share to $1.00 per share, which amount will be paid on April 14, 2023 to all stockholders of record as of the close of business on March 31, 2023.

Other Long-Term Obligations

Other long-term obligations primarily include payments for deferred compensation plan liabilities and accrued dividend equivalents. As of December 31, 2022, these obligations totaled $71.7 million.

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