# SITIME Corp (SITM) FY 2021 MD&A

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

SEC filing source: https://www.sec.gov/Archives/edgar/data/1451809/000095017022002096/sitm-20211231.htm
Accession: 0000950170-22-002096
Filing date: 2022-02-25
Report date: 2021-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Published MD&A gate trimmed front/tail over-capture.
Confidence: high

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

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 (“MD&A”) should be read in conjunction with the financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. The MD&A contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that involve risks and uncertainties, which are discussed under Item 1A.

Overview

We are a leading provider of silicon timing solutions. Our timing solutions are the heartbeat of our customers’ electronic systems. They solve complex timing problems and enable industry-leading products. We provide solutions that are differentiated by high performance and reliability, programmability, small size, and low power consumption. Our products have been designed into over 250 applications across our target markets, including communications and enterprise, automotive, industrial, aerospace, mobile, IoT and consumer.

In 2021, we advanced our technology, expanded our product portfolio, increased our worldwide workforce, and generated a significant increase in revenue and profit. We saw continued strong revenue growth, increased gross margins, increased operating margins, increased net income and positive cash flow. Revenue grew 88% from $116.2 million in 2020 to $218.8 million in 2021. Gross margins increased by 14% from 50% in 2020 to 64% in 2021, while operating margins expanded from a 7% loss in 2020 to a 15% income in 2021. In addition, we raised $460.6 million during the year from our two stock offerings.

We commenced commercial shipments of our first oscillator products in 2006. Substantially all of our revenue to date has been derived from sales of oscillator systems across our target end markets. We intend to focus on clock IC and timing sync solutions in the future. We seek to aggressively expand our presence in these two markets.

We sell our products primarily through distributors and resellers, who in turn sell to our end customers. We also sell products directly to end customers who integrate our products into their applications. Based on sell-through information provided by our distributors, we believe the majority of our end customers are based in the U.S.

We operate a fabless business model, allowing us to focus on the design, sales, and marketing of our products, quickly scale production, and significantly reduce our capital expenditures. We leverage our global network of distributors and resellers to address the broad set of end markets we serve. For our largest accounts, dedicated sales personnel work with the end customer to ensure that our solutions fully address the end customer’s timing needs. Our smaller customers work directly with our distributors to select the optimum timing solution for their needs.

We were acquired by MegaChips in 2014 and were a wholly-owned subsidiary of MegaChips, a fabless semiconductor company based in Japan and traded on the Tokyo Stock Exchange, until November 25, 2019. On November 25, 2019, we completed the initial public offering of shares of our common stock. On June 16, 2020, we completed a follow-on public offering, in which we issued and sold 1,525,000 shares of our common stock and MegaChips sold 2,500,000 shares of our common stock held by it. On February 22, 2021, we completed an additional follow-on public offering, in which we issued and sold 1,500,000 shares of our common stock and MegaChips sold 1,500,000 shares of our common stock held by it. On November 10, 2021 we completed a follow-on public offering, in which we issued and sold 1,300,000 shares of our common stock and MegaChips sold 1,000,000 shares of our common stock held by it. MegaChips continues to be our largest stockholder and held approximately 24.0% of our common stock as of December 31, 2021.

We are currently experiencing a growth in demand for some of our products, however, there are a number of industry-wide supply constraints affecting the supply of analog circuits manufactured by certain foundries, including Taiwan Semiconductor Manufacturing Company, and affecting outsourced semiconductor assembly and test providers, which may limit our ability to fully satisfy the increase in demand. If we cannot ship our products to our customers on time and in the quantity required as a result of this supply constraint our sales could decline or could grow at a lower rate and we could lose customers. We believe that the effects of the industry-wide supply constraints on other timing device suppliers have contributed in part to our revenue and gross margin growth in 2021; however, we may not be able to sustain these revenue and gross margin increases in the future. It is not clear how long the industry-wide supply constraints will continue, or what the resulting impact will be on our gross margin and revenue when the industry-wide supply constraints resolve. For additional discussion please see Part I, Item 1A Risk Factors of this report, especially the risk factor titled “Our revenue and operating results may fluctuate from period to period, which could cause our stock price to fluctuate."

Impact of COVID-19 on our Business

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The future impact of the ongoing COVID-19 pandemic on our business remains unknown. In an effort to protect the health and safety of our employees, we implemented safety measures at our locations around the world, including requiring employees to work from home (“WFH”) in certain locations at times, reducing the number of people in certain of our sites at any one time, and limiting employee travel. In an effort to contain the COVID-19 pandemic or slow its spread, governments around the world have also enacted various measures, including orders to close all businesses not deemed “essential,” isolate residents in their homes or places of residence, and practice social distancing. In addition, the United States and other countries in which we operate have from time to time imposed measures such as quarantines and “shelter-in-place” orders that restrict business operations and travel and require individuals to WFH, which has impacted all aspects of our business, as well as those of the third-parties we rely upon for our manufacturing, assembly, testing, shipping and other operations. The current and future spread of COVID-19 variants may cause the reinstatement of one or more of these measures.

We anticipate the COVID-19 pandemic will continue to impact business activity across the globe and will continue to impact our business, employees and operations for the foreseeable future. We believe that as a result of the COVID-19 pandemic we have experienced some delay and disruption in the manufacture, shipment, and sales of our products. In addition, we believe the production capabilities of our suppliers has been, and will likely continue to be, impacted as a result of quarantines, closures of production facilities, lack of supplies, or delays caused by restrictions on travel or WFH orders. These restrictions could limit our suppliers’ ability to operate their manufacturing facilities in that country. Any delay or disruption in the manufacture, shipment and sales of, or overall demand for, our products in turn may negatively and materially impact our operating and financial results, including revenue, gross margins, operating margins, cash flows and other operating results. Further, the resumption of normal business operations after such disruptions may be delayed and a resurgence of COVID-19 could result in continued disruption to us, our suppliers, and/or our customers. To date, we have experienced minimal impact from any supplier disruption resulting from COVID-19.

The duration and full magnitude of the COVID-19 pandemic’s impact on credit and financial markets is also unknown, which creates uncertainty as to the financial condition of our distributors or customers. In addition, the deterioration in credit markets could limit our ability to obtain external financing to fund our operations and capital expenditures. We may also experience losses on our holdings of cash and investments due to failures of financial institutions and other parties.

We currently have employees, third-party contractors, distributors, and customers in numerous countries throughout the world that have been impacted by the COVID-19 pandemic. The COVID-19 pandemic has restricted and is expected to continue to restrict travel and use of our facilities and the facilities of our suppliers, customers, or other vendors in our supply chain, which could impact our business, interactions and relationships with our customers, third-party suppliers and contractors, and results of operations. We cannot predict with certainty what other impacts the COVID-19 pandemic may have on our business, employees, service providers, customers and results of operations.

There remains a high degree of uncertainty in the global business environment given the impact of the COVID-19 pandemic which creates challenges with visibility beyond the near term. Further, as WFH orders terminate and individuals return to work in offices, we may experience a reduction in demand for certain of our products that are incorporated in our customers’ products that experienced higher demand as a result of the increase in WFH during the COVID-19 pandemic. We will continue to actively monitor the situation and may take further actions altering our business operations that we determine are in the best interests of our employees, customers, partners, suppliers, and stakeholders, or as required by federal, state, or local authorities. It is not clear what the potential effects any such alterations or modifications may have on our business, including the effects on our customers, employees, operations, and prospects, or on our financial results for 2022 and beyond. For additional discussion, please see Part I, Item 1A Risk Factors of this report.

Key Factors Affecting Our Performance

Customer Orders and Forecasts

Because our sales are made pursuant to standard purchase orders, orders may be cancelled, reduced, or rescheduled with little or no notice and without penalty. Cancellations of orders could result in the loss of anticipated sales without allowing us sufficient time to reduce our inventory and operating expenses. In addition, changes in forecasts or the timing of orders from customers exposes us to the risks of inventory shortages or excess inventory. We may not be able to fulfill increased demand, at least in the short term, as we do not intend to acquire excess inventory to pre-build custom products.

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Design Wins with New and Existing Customers

Our solutions enable our customers to differentiate their product offerings and position themselves to gain market share. We work closely with our customers to understand their product roadmaps and strategies. Our end customers continuously develop new products in existing and new application areas. We also consider design wins critical to our future success and anticipate being increasingly dependent on revenue from new design wins for our new higher-end products with higher average selling prices (“ASPs”). The selection process is typically lengthy and may require us to incur significant design and development expenditures in pursuit of a design win with no assurance that our solutions will be selected. As a result, the loss of any key design win or any significant delay in the ramp of volume production of the customer’s products into which our product is designed could adversely affect our business.

Customer Demand and Product Life Cycles

Once customers design our silicon timing systems solutions into their products, we closely monitor all aspects of their demand cycle, including the initial design phase, prototype production, volume production, and inventories, as well as end-market demand, including seasonality, cyclicality, and the competitive landscape. Given our customer relationships and the long-term aspects of our solutions, we benefit from visibility into customer demand. This in turn provides an opportunity for us to monitor and refine our business fundamentals.

Product Adoption within New Markets and Applications

As we evaluate new market opportunities and bring new products to market, we pay particular attention to forecasts by industry analysts and the adoption curve of technology. We also analyze in detail potential competing forces that could hinder such adoption. If we fail to anticipate or respond to technological shifts or market demands, or to timely develop new or enhanced products or technologies in response to the same, it could result in decreased revenue and the loss of our design wins to our competitors.

Pricing, Product Cost, and Product Mix

The ASPs of our products vary significantly. While the ASP of any individual product generally decreases over time, our average ASPs have historically remained relatively flat as we continue to introduce new higher-end products with higher ASPs. Our pricing and margins depend on customer demand as well as the volumes and the features of the timing devices we provide to our customers. We continually monitor and work to reduce the cost of our products and improve the potential value our solutions provide to our customers as we target new design win opportunities and manage the product life cycles of our existing customer designs. Since we rely on third-party wafer foundries and assembly and test contractors to manufacture, assemble, and test our products, we maintain a close relationship with our suppliers to improve quality and increase yields.

Gross margin, or gross profit as a percentage of revenue, has been, and will continue to be, affected by a variety of factors, including ASPs, and product mix in a given period, material costs, yields, inventory write-downs and manufacturing operations costs. We believe the primary driver of gross margin is the ASPs negotiated between us and our customers relative to material costs and yield improvement. As our products mature and unit volumes increase, we expect their ASPs to decline. These declines often coincide with improvements in manufacturing yields and lower wafer, assembly, and testing costs, which offset some or all of the margin reduction that results from lower ASPs. However, we expect our gross margin to fluctuate on a quarterly basis as a result of changes in ASPs due to new product introductions, existing product transitions into high-volume manufacturing, manufacturing costs, and our product mix.

Cyclical Nature of the Semiconductor Industry

The semiconductor industry is highly cyclical and is characterized by constant and rapid technological change, rapid product obsolescence, price erosion, evolving standards, short product life cycles, and wide fluctuations in product supply and demand. Downturns in the semiconductor industry have been characterized by diminished product demand, production overcapacity, high inventory levels, and accelerated erosion of average selling prices. Any prolonged or significant downturn in the semiconductor industry generally could adversely affect our business and reduce demand for our products and otherwise harm our business, financial condition and results of operations. Furthermore, any significant upturn in the semiconductor industry could result in increased competition for access to third-party foundry and assembly capacity. We are dependent on the availability of this capacity to manufacture and assemble our products and we can provide no assurance that adequate capacity will be available to us in the future.

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Results of Operations

The following table summarizes our results of operations for the periods presented.

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A discussion of changes in our results of operations from fiscal 2019 to fiscal 2020 has been omitted from this Form 10-K, but may be found in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Form 10-K for fiscal 2020 filed with the Securities and Exchange Commission on February 16, 2021.

Revenue

We derive revenue primarily from sales of silicon timing products to distributors and resellers who in turn sell to our end customers. We also sell products directly to end customers who integrate our products into their applications. Our sales are made pursuant to standard purchase orders which may be cancelled, reduced, or rescheduled, with little or no notice. We recognize product revenue upon shipment when we satisfy our performance obligations as evidenced by the transfer of control of our products to customers. We measure revenue based on the amount of consideration we expect to be entitled to in exchange for products.

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Revenue increased by $102.7 million, or 88%, for 2021 compared to 2020. The increase was primarily related to 34% higher volume of shipments year over year and a 40% increase in average selling price ("ASP") of our products. The increase in sales volume was driven by higher demand for our products from new and existing customers, including new design wins at our existing customers. The ASP increase was related to change in mix of the products we shipped and increase in selling prices for certain products.

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Cost of Revenue, Gross Profit, and Gross Margin

Cost of revenue consists of wafers acquired from third-party foundries, assembly, packaging, and test cost of our products paid to third-party contract manufacturers, and personnel and other costs associated with our manufacturing operations. Cost of revenue also includes depreciation of production equipment, inventory write-downs, amortization of internally developed software, shipping and handling costs, and allocation of overhead and facility costs. We also include credits for rebates received from foundries to cost of revenue.

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Gross profit increased by $81.5 million in the year ended December 31, 2021 compared to the same period in 2020. Gross profit increased $86.6 million mainly from higher sales volume and an increase in ASPs of our products. This increase was offset by higher other manufacturing and overhead costs of $5.1 million of which $1.0 million was related to higher stock-based compensation expense.

Gross margin was higher by 14% in the year ended December 31, 2021 compared to the same period in 2020. The gross margin increased by 11% from higher sales volume and an increase in ASPs. There was additional 3% improvement in our other manufacturing costs as it decreased as a percentage of revenue.

We expect to see increases in our manufacturing costs in fiscal year 2022 due to an industry wide increase in costs. Gross margin may fluctuate from time to time due to a variety of factors.

Operating Expenses

Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs are the most significant component of our operating expenses and consist of salaries, benefits, bonuses, stock-based compensation, and commissions. Our operating expenses also include consulting costs, allocated costs of facilities, information technology, and depreciation.

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Research and Development

Our research and development efforts are focused on the design and development of next-generation silicon timing systems solutions. Our research and development expense consists primarily of personnel costs, which include stock-based compensation, pre-production engineering mask costs, software license and intellectual property expenses, design tools and prototype-related expenses, facility costs, supplies, professional and consulting fees, and allocated overhead costs, offset by non-recurring engineering service credits. We expense research and development costs as incurred. We believe that continued investment in our products and services is important for our future growth and acquisition of new customers and, as a result, we expect our research and development expenses to continue to increase in absolute dollars. However, we expect our research and development expense to fluctuate as a percentage of revenue from period to period depending on the timing of these expenses.

Research and development expense increased by $20.5 million, or 65%, for the year ended December 31, 2021 compared to the same period in 2020, primarily due to higher personnel costs of $10.0 million due to increased headcount, an increase in stock-based compensation expense of $6.1 million, and higher ongoing new product related expenses of $6.9 million primarily consisting of consulting and supplies. These were offset by non-recurring engineering contra-expense recognized of $2.4 million.

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Sales, General and Administrative

Sales, general and administrative expense consists of personnel costs, including stock-based compensation, professional and consulting fees, accounting and audit fees, legal costs, field application engineering support, travel costs, advertising expenses, and allocated overhead costs. We expect sales, general and administrative expense to continue to increase in absolute dollars as we increase our personnel and grow our operations, although it may fluctuate as a percentage of revenue from period to period depending on the timing of these expenses.

Selling, general and administrative expense increased by $19.6 million, or 56%, for the year ended December 31, 2021 compared to the same period in 2020, primarily due to higher stock-based compensation expense of $6.2 million, higher personnel costs of $4.2 million, higher commission expenses of $4.5 million due to increased revenue, and higher consulting fees of $3.4 million.

Other Expense

Other expense consists primarily of interest expense on our outstanding debt, interest income on our cash balances, and foreign exchange gains and losses. See Note 7 to our consolidated financial statements under Item 8 for more information about our debt.

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Other expense decreased $0.3 million for the year ended December 31, 2021 compared to the same period in 2020, primarily as a result of no interest expense in 2021 on our outstanding revolving short-term debt as we paid in full all of our debt on July 24, 2020, offset by a net unrealized loss on foreign exchange rates due to increased activities in our foreign subsidiaries.

Income Tax Benefit (Expense)

Income tax expense consists primarily of state income taxes and income taxes in certain foreign jurisdictions in which we conduct business. We have a full valuation allowance for deferred tax assets as the realization of the full amount of our deferred tax asset is uncertain, including net operation losses (NOL), carryforwards, and tax credits related primarily to research and development. We expect to maintain this full valuation allowance until realization of the deferred tax assets becomes more likely than not. At December 31, 2021 and 2020, we had federal NOL carry-forwards of approximately $259.6 million and $201.5 million, respectively, and state NOL carry-forwards of approximately $64.5 million and $64.0 million, respectively. We had research and development tax credit carryforwards of approximately $3.9 million and $3.9 million, respectively for U.S. federal income tax purposes and $3.6 million and $3.6 million, respectively for state income tax purposes. Of the federal NOL carryforwards, approximately $148.4 million will expire in various years through 2036, if not utilized, and approximately $111.2 million will carry forward indefinitely. NOL carryforwards for state income tax purposes, if not utilized, will expire in various years through 2040. The research and development credit carryforwards for federal tax purposes will expire in various years through 2038, and state tax credits carry forward indefinitely.

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Liquidity and Capital Resources

As of December 31, 2021 and 2020, we had cash and cash equivalents of $559.5 million and $73.5 million, respectively. Historically, the primary sources of our liquidity have been cash generated from our operations and the issuance of shares of our common stock. In June 2020, we completed a follow-on public offering of our shares, resulting in net proceeds to us of $45.8 million after deducting underwriting discounts and commissions and deferred offering costs. On July 24, 2020, we paid down all outstanding loans with The Bank of Tokyo Mitsubishi UFJ, Ltd. ("MUFG") of $35.0 million and closed our credit facilities with MegaChips Corporation and Sumitomo Mitsui Banking Corporation ("SMBC"). On February 22, 2021, we completed an additional follow-on

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public offering, in which we issued and sold 1,500,000 shares of our common stock, resulting in net proceeds to us of $181.6 million after deducting underwriting discounts and commissions and deferred offering costs. On November 10, 2021 we completed a follow-on public offering, in which we issued and sold 1,300,000 shares of our common stock, resulting in net proceeds to us of $279.0 million after deducting underwriting discounts and commissions and deferred offering costs.

Our principal use of cash is to fund our operations to support growth. Our purchase obligations primarily include design and simulation licenses. As of December 31, 2021, such purchase obligations were $5.4 million. For information about our contractual obligations refer to "Note 5 - Lease" and “Note 6 – Commitments and Contingencies” of the Notes to Consolidated Financial Statements.

We expect to continue our investing activities, primarily in the purchase of property and equipment and capitalized software, to support research and development, sales and marketing, product support, and administrative staff.

We believe that our existing cash and cash equivalents will be sufficient to meet our cash needs for at least the next 12 months. Over the longer term, our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our sales and marketing and research and development expenditures, and the continuing market acceptance of our solutions. In the event that we need to borrow funds or issue additional equity, we cannot provide any assurance that any such additional financing will be available on terms acceptable to us, if at all. If we are unable to raise additional capital when we need it, it would harm our business, results of operations and financial condition.

Cash Flows

The following table summarizes our cash flows for the periods indicated:

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Operating Activities

In 2021, net cash provided by operating activities of $59.1 million was primarily due to net income of $32.3 million and non-cash expenses of $39.9 million, partially offset by a change in operating assets and liabilities of $13.1 million, Non-cash expenses were mainly related to depreciation and amortization and stock-based compensation expense. The changes in operating assets and liabilities resulted in cash provided primarily due to higher accounts receivables due to timing of shipments and an increase in inventories as we managed our inventory levels, partially offset by lower prepaid expenses and other current assets related to advance payments to suppliers for inventory and higher accounts payable and accrued expenses and other liabilities due to timing of payments.

In 2020, net cash provided by operating activities of $16.6 million was primarily due to a net loss of $9.4 million being more than offset by non-cash expenses of $24.9 million and a change in operating assets and liabilities of $1.1 million. Non-cash expenses were mainly related to depreciation and amortization, stock-based compensation expense, inventory write-down, and impairment of internal-use software. The changes in operating assets and liabilities resulted in cash provided primarily due to higher accounts receivables due to timing of shipments and an increase in inventories as we managed our inventory levels being more than offset by lower prepaid expenses and other current assets related to advance payments to suppliers for inventory and higher accounts payable and accrued expenses and other liabilities due to timing of payments.

Investing Activities

Our investing activities consist primarily of capital expenditures for property and equipment purchases. Our capital expenditures for property and equipment have primarily been for general business purposes, including machinery and equipment, leasehold improvements, acquired software, internally developed software used in production and support of our products, computer equipment used internally, and production masks to manufacture our products.

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In 2021, cash used in investing activities was $33.8 million. We paid $30.9 million largely to purchase test and other manufacturing equipment to support the increase in demand of our products and other property and equipment for general business purposes. We paid $2.9 million to purchase intangible assets.

In 2020, cash used in investing activities was $7.8 million and consisted primarily of the purchase of production masks, internally developed software, and other property and equipment for general business purposes.

Financing Activities

Cash provided by financing activities includes proceeds from borrowings and payments under our credit facilities and proceeds from issuance of shares.

In 2021, cash provided by financing activities was $460.6 million, consisting of proceeds from issuance of shares of $461.3 million net of underwriting commissions and discounts of $21.7 million and deferred offering costs of $0.6 million.

In 2020, cash provided by financing activities was $1.3 million, consisting of proceeds from issuance of shares of $45.8 million net of underwriting commissions and discounts of $2.7 million and deferred offering costs of $0.3 million and borrowings of $35.0 million offset by repayments of $76.0 million under our short-term revolving line of credit and $3.5 million payment of tax withholdings paid on behalf of employees for net share settlement at the time of vesting.

Critical Accounting Estimates

Our consolidated financial statements have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

The critical accounting policies requiring estimates, assumptions, and judgments that we believe have the most significant impact on our consolidated financial statements are described below.

Revenue Recognition

We derive our revenue from product sales to distributors and resellers, who in turn sell to original equipment manufacturers or other end customers. We recognize product revenue, at a point in time, upon shipment when we satisfy our performance obligations as evidenced by the transfer of control of our products to customers. We measure revenue based on the amount of consideration we expect to be entitled to in exchange for products. Variable consideration is estimated and reflected as an adjustment to the transaction price. We determine variable consideration at the end of each reporting period, which consists primarily of price adjustments and product returns by estimating the amount of consideration we expect to receive from our customers based on historical experience. If variable considerations are anticipated to exceed historical experience, we may adjust our sales returns allowance accordingly to properly reflect our net revenue. Since our performance obligations relate to contracts with a duration of less than one year, we do not disclose the aggregate amount of the transaction price allocated to performance obligations that are unsatisfied or partially unsatisfied at the end of the reporting period.

Inventories

Inventories consist of raw materials, work-in-process, and finished goods and are stated at the lower of standard cost, determined using first-in first out method or market net realizable value. We review and set standard costs to approximate actual manufacturing costs. We perform detailed reviews of the net realizable value of inventories, both on hand as well as for inventories that we are committed to purchase at the end of each reporting period. We write-down the inventory value for estimated deterioration, excess, obsolete and other factors based on management’s assessment of future demand and market conditions of our inventory. These estimates may include uncertain elements such as our demand forecast. These forecasts are developed based on current backlogs, inputs from our customers, and internal analyses which may consists of customer historical purchasing trends, actual and anticipated design wins, market and economic conditions, technology changes, new product introductions, changes in strategic direction and other factors. If our demand forecast for specific products is greater than actual demand and we fail to reduce manufacturing output

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accordingly, we could be required to write down additional inventory, which would have a negative impact on our gross margin. Once written-down, inventory write-downs are not reversed until the inventory is sold or scrapped.

Stock-Based Compensation

Stock-based compensation expense is measured at the grant date based on the fair value of the equity award and is recognized as expense over the requisite service period, which is generally the vesting period. We have elected to recognize forfeitures as they occur.

The fair value of each restricted stock unit is estimated based on the market price of our common shares on the date of grant.

We amortize stock-based compensation expense for time-based awards under the straight-line attribution method over the vesting period. Stock-based compensation expense for performance-based awards is recognized when it becomes probable that the performance conditions will be met. We amortize stock-based compensation expense for performance-based awards using the accelerated method.

Income Taxes

Deferred tax liabilities and assets are recognized for the expected future tax consequences of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities and net operating loss and tax credit carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets to a level which, more likely than not, will be realized.

A tax position can be recognized only if it is more likely than not to be sustained based solely on its technical merits as of the reporting date and then only in an amount more likely than not to be sustained upon review by the tax authorities. We consider many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.

Recent Accounting Pronouncements

See Note 2 to our consolidated financial statements under Item 8 for information regarding recently issued accounting pronouncements.