Form 10-Q for AGERE SYSTEMS INC
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9-Aug-2004
Quarterly Report
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read in conjunction with our unaudited financial statements for the three and nine months ended June 30, 2004 and 2003 and the notes thereto. This discussion contains forward-looking statements. Please see Forward-Looking Statements and Factors Affecting Our Future Performance for a discussion of the uncertainties, risks and assumptions associated with these statements.
Overview
We provide advanced integrated circuit solutions that are made using semiconductor wafers imprinted with a network of electronic components. They are designed to perform various functions such as processing electronic signals, controlling electronic system functions and processing and storing data.
Our business operations are divided into two market-focused groups, Client Systems and Infrastructure Systems. The Client segment targets the computer and consumer communications market and the Infrastructure segment targets the network equipment market. Each of these two groups is a reportable operating segment. The segments each include revenue from the licensing of intellectual property. The Client segment provides integrated circuit solutions for a variety of end-user applications such as hard disk drives and modems for computers, data-enabled mobile phones and wireless local area networking. The Infrastructure segment provides integrated circuit solutions to makers of high-speed communications systems. In addition, the Infrastructure segment formerly provided optoelectronic components; however, we have sold those operations and have reflected them as discontinued operations for all periods presented. See Note 6 to our financial statements in Item 1 of Part 1 for additional details.
Effective during the fourth quarter of fiscal 2004, we will realign our business to focus on four key markets: Mobility, Storage, Enterprise and Networking, and Telecommunications. The Mobility division will include our mobile phone, Wi-Fi, voice over IP and mobile entertainment device integrated circuits. The Storage division will include our integrated circuits for hard disk drives. The Enterprise and Networking division will include custom solutions, modem integrated solutions and computer input/output products. The Telecommunications division will include solutions for wireless and wireline infrastructure.
Operating Environment
Our business depends in large part on demand for personal computers and associated equipment, wireless communications equipment such as mobile phones and telecommunications infrastructure equipment. Our revenues can be affected by changes in demand for any of these types of products. The Client segment depends on demand for mobile phones and personal computers and associated equipment. The Infrastructure segment depends on demand for telecommunications infrastructure equipment. Our markets are competitive and rapidly changing and significant technological changes, new customer requirements, changes in customer buying behavior or the emergence of competitive products with new capabilities or technologies could adversely affect our revenues and operating results.
Our revenue in the quarter ending September 30, 2004 is expected to be below the level we achieved in the quarter ended June 30, 2004, principally due to weaker sales of integrated circuits used in mobile phones and wireless infrastructure products and lower intellectual property licensing revenue. We expect that the lower revenue will result in a somewhat lower gross margin percentage for the September quarter.
Sales of integrated circuits used in mobile phones are expected to be significantly weaker in the September quarter than in the June quarter. Our sales of integrated circuits used in mobile phones based on the UMTS/W-CDMA, or 3G, standard are concentrated in one customer. We believe this customer has sufficient inventory of our product to meet its near-term requirements and we do not currently believe we will sell integrated circuits for 3G mobile phones to this customer in the September quarter. On June 30, 2004, we had $17 million of 3G inventory and $11 million of in process 3G material at third party manufacturers. Our sales of integrated circuits used in GPRS/EDGE based mobile phones
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are concentrated in two major customers and several smaller customers. We believe inventory issues at one of our smaller customers in China will result in reduced sales of integrated circuits used in GPRS/EDGE based mobile phones in the September quarter. Our sales to our remaining GPRS/EDGE customers could be negatively impacted by inventory levels at these customers if end-user demand for their products weakens. We expect our sales of integrated circuits to wireless infrastructure customers to decline in the September quarter from the very strong levels seen in the June quarter. We sell integrated circuits for use in hard disk drives to two major customers and several smaller customers. We believe that our sales of integrated circuits for use in hard disk drives were negatively impacted in the June quarter by inventory issues at those major customers and we believe this condition will continue into the September quarter.
The integrated circuit manufacturing industry has a history of developing new manufacturing processes. We believe that the costs associated with implementing new processes, including acquiring the necessary equipment and building appropriate facilities, are increasing with each generation of manufacturing processes. Because we do not want to make the financial investments necessary for future processes, we plan to increase our reliance on third-party contract manufacturers to make integrated circuits for us. We refer to this strategy as our fab-lite strategy. We believe this strategy will lead to lower capital expenditures, fixed costs and process development expenses than if we continued to invest in new manufacturing facilities.
Restructuring and Decommissioning Activities
We have substantially completed a major restructuring of our business which we began in fiscal 2001. We undertook this restructuring in response to significant declines in our revenue, particularly from our telecommunications network equipment customers. We believe that our customers were themselves experiencing significant declines in demand from their customers. As part of this restructuring, we:
Sold our optoelectronic components business, including the manufacturing facilities associated with that business;
Reduced our total headcount by approximately 9,700 employees;
Consolidated our operations into fewer facilities resulting in the closure of over 25 smaller manufacturing, administrative, support and warehouse facilities; and
Closed integrated circuit wafer manufacturing facilities in Allentown and Reading, Pennsylvania and Madrid, Spain.
We also achieved our goal of a breakeven on quarterly revenues of approximately $450 million to $500 million. No significant additional savings from these restructuring activities are anticipated. Substantially all of the product lines eliminated by the restructuring activities were concentrated within the optoelectronics business.
As a result of our restructuring activities, we recorded $1 million and $33 million for the three and nine months ended June 30, 2004, respectively, for the decommissioning of our former manufacturing facilities in Allentown and Reading. We recorded $10 million and $32 million for the three and nine months ended June 30, 2004, respectively for net restructuring and related charges. These are classified within restructuring and other chargesnet. The net charges for the three months ended June 30, 2004 include $7 million related to international workforce reductions and $3 million related to rationalization of under-utilized manufacturing facilities and other restructuring related activities, including relocation of employees and equipment. The net charges for the nine months ended June 30, 2004 include $16 million related to domestic and international workforce reductions and revisions of prior estimates, and $16 million related to the rationalization of under-utilized manufacturing facilities and other restructuring activities, including relocation of employees and equipment. In addition, within gross margin we recorded $6 million of restructuring related charges during the nine months ended June 30, 2004, of which $5 million resulted from increased depreciation. This additional depreciation is due to the shortening of estimated useful lives of certain assets in connection with our restructuring actions.
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For additional details regarding our restructuring activities, see Note 4 to our financial statements in Item 1 of Part 1.
We recorded $6 million and $99 million for the three and nine months ended June 30, 2003, respectively for net restructuring and related charges. The net charges for the three months ended June 30, 2003 include $3 million related to workforce reductions and $3 million related to rationalization of under-utilized manufacturing facilities and other restructuring related activities, including relocation of employees and equipment. The net charges for the nine months ended June 30, 2003 include $49 million related to workforce reductions and $50 million related to the rationalization of under-utilized manufacturing facilities and other restructuring activities, including relocation of employees and equipment. For the three and nine months ended June 30, 2003 within gross margin, we recorded $32 million and $86 million, respectively of restructuring related costs, of which $22 million and $63 million, respectively, resulted from increased depreciation.
To complete our remaining restructuring and decommissioning actions, we estimate that we will incur approximately $20 million in additional cash charges, the majority of which is for the remaining consolidation of employees to our Lehigh Valley facility and the costs associated with completing the decommissioning of our former manufacturing sites in Allentown and Reading. We also expect to spend an additional $9 million for capital expenditures related to our restructuring and consolidation actions.
Application of Critical Accounting Policies and Estimates
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the periods reported. The following accounting policies involve a critical accounting estimate because they are particularly dependent on estimates and assumptions made by us about matters that are highly uncertain at the time the accounting estimates are made. See Item 7Management's Discussion and Analysis of Financial Condition and Results of OperationsApplication of Critical Accounting Policies and Estimates in our Annual Report on Form 10-K for the fiscal year ended September 30, 2003, for additional critical accounting policies and estimates.
In-process research and development
We review our acquisitions to determine if there are any intangible assets relating to purchased in-process research and development. Projects that have not achieved technological feasibility and have no alternative future use are valued at fair market value using a discounted cash flow analysis and are expensed in the statement of operations on the date of acquisition. We use a discount rate that reflects the development stage of the technology and the risks associated with attaining full technological and commercial feasibility. When we value in-process research and development, we must make a number of estimates, including the timing and amounts of future cash flows to be generated as a result of the projects, how close the projects are to technological feasibility and how much risk and cost is involved in finalizing the projects. It is reasonably likely that our estimates for these amounts will differ from actual results, in which case our in-process research and development charge may be over- or under- valued, which would also result in an under- or over-valuation of our goodwill.
Property, Plant and Equipment
Property, plant and equipment that is held and used is generally reflected in our financial statements at historical cost less an allocation for depreciation. The resulting book value may not be reflective of its fair market value. However, we have impaired property, plant and equipment in connection with our restructuring initiatives. Property, plant and equipment is reviewed for impairment whenever events such as a significant industry downturn, product discontinuance, plant closures, product dispositions, technological obsolescence, or other changes in circumstances indicate that their carrying amount may not be recoverable. We perform impairment tests on groups of assets that are related and have separately identifiable cash flows. In some cases, it may not be practical to measure the
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cash flows associated with a particular asset or group of assets due to the integrated nature of our production process. When an asset's economic life is shorter than previously expected or when we plan to abandon an asset as a result of a restructuring plan or otherwise and are unable to measure the associated cash flows, we shorten the recovery period for that asset to its remaining useful life, which would cause us to recognize increased depreciation. If separate cash flows can be identified, we compare the carrying amount of the assets to their undiscounted expected future cash flows. If an impairment exists, assets classified as held and used are written-down to fair value and are depreciated over their remaining useful life, while assets classified as held for sale are written down to fair value less costs to sell. It is reasonably likely that the actual fair value may differ from our current estimate, in which case we may under- or over-value our property, plant and equipment and under- or over-value the related impairment charge.
Results of Operations
Three months ended June 30, 2004 compared to the three months ended
June 30, 2003
The following table shows the change in revenue, both in dollars and in
percentage terms by segment:
Three Months
Ended
June 30, Change
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2004 2003 $ %
------- ------- ------ ------
(Dollars in Millions)
Segment Revenue:
Client Systems $ 349 $ 324 $ 25 8 %
Infrastructure Systems 146 132 14 11
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Total $ 495 $ 456 $ 39 9 %
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Revenue. Revenue increased 9% or $39 million, for the three months ended June 30, 2004, as compared to the same period in 2003. The revenue increase of $25 million in the Client segment is comprised of an $18 million increase in product revenue and a $7 million increase in intellectual property licensing revenue. The $18 million product revenue increase was driven by volume increases in the sales of integrated circuits used in mobile phones, partially offset by price and volume declines in the sales of integrated circuits used in hard disk drives. We also had lower revenues in wireless local area networking resulting from lower demand for our 802.11b solutions, and had pricing pressures throughout the remainder of the segment. The revenue increase of $14 million in the Infrastructure segment is comprised of an $8 million increase in intellectual property licensing revenue and a $6 million increase in product revenue. The $6 million product revenue increase primarily reflects volume increases from wireless digital signal processors, wireless infrastructure devices and public infrastructure devices, partially offset by volume decreases in mature telephony devices and broadband access devices, as demand for older telecommunications-focused products continued to decline, and a decrease in enterprise networking devices as that product portfolio continues to mature.
Gross margin. Gross margin increased from 29.6% in the prior year quarter to 46.1% in the current quarter, an increase of 16.5 percentage points. Gross margin for the Client segment increased to 36.7% in the current quarter from 19.4% in the prior year quarter. The Client segment gross margin was positively impacted by a $26 million decrease in restructuring related costs, higher capacity utilization driven by stronger demand for integrated circuits for mobile phones and the closure of our Allentown and Reading manufacturing facilities, and higher intellectual property revenues, partially offset by price erosion across the segment. Gross margin for the Infrastructure segment increased to 68.5% in the current quarter from 54.5% in the prior year quarter. The Infrastructure segment gross margin improvement was due to the combination of higher manufacturing capacity utilization, a $7 million decrease in restructuring related costs, increased intellectual property revenue, and a change in mix to higher margin product applications.
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Selling, general and administrative. Selling, general and administrative expenses decreased 16% or $12 million, from $76 million in the three months ended June 30, 2003 to $64 million in the three months ended June 30, 2004. The decrease is due to expense reductions in information technology, worldwide sales and corporate functions as a result of restructuring actions and decreased bonus accruals for short-term incentive plans.
Research and development. Research and development expenses increased 12% or $14 million, from $117 million in the prior year quarter to $131 million in the current quarter. The increase was due to higher design-related investments and increased headcount in support of the mobile phone, ethernet, storage and wireless networking areas, higher information technology expense, and higher mask expense. These increases were partially offset by a lower investment in silicon manufacturing process research due to our conversion to a fab-lite business model and a decrease in bonus accruals for short-term incentive plans.
Restructuring and other chargesnet. Net restructuring and other charges increased 83% or $5 million to $11 million for the three months ended June 30, 2004 from $6 million for the three months ended June 30, 2003. See Note 4 to our financial statements in Item 1 of Part 1 for additional details.
Operating income (loss). We reported operating income of $23 million for the three months ended June 30, 2004, an improvement of $74 million from an operating loss of $51 million for the three months ended June 30, 2003. This improvement in operating income (loss) is the result of a $93 million increase in gross profit offset by a $19 million increase in operating expenses.
Although we conduct performance measurement and resource allocation for the reportable segments based on many factors, the primary financial measure used is operating income (loss) by segment, exclusive of amortization of acquired intangible assets, purchased in-process research and development, net restructuring and other charges and net gain on sale of operating assets, which is shown in the following table.
Three Months
Ended
June 30, Change
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2004 2003 $ %
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(Dollars in Millions)
Segment Operating Income (Loss):
Client Systems $ 13 $ (48 ) $ 61 N/M
Infrastructure Systems 20 (10 ) 30 N/M
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Total $ 33 $ (58 ) $ 91 N/M
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N/M = Not Meaningful
Other income (expense)net. Net other income (expense) decreased $4 million, from $3 million income in the prior year quarter to $1 million expense in the current quarter. This decrease is a result of a decrease in equity earnings from our joint venture, Silicon Manufacturing Partners, or SMP.
Provision (benefit) for income taxes. For the three months ended June 30, 2004, we recorded a provision for income taxes of $9 million on pre-tax income from continuing operations of $11 million, yielding an effective tax rate of 81.8%. This rate differs from the U.S. statutory rate primarily due to recording $11 million in the current quarter for taxes related to non-U.S. jurisdictions, which included an $8 million year to date adjustment, a $4 million reversal of tax and interest contingencies resulting from a settlement arising from a tax period we operated as a division of Lucent Technologies Inc., and the recording of a full valuation allowance against U.S. net deferred tax assets. For the three months ended June 30, 2003, we recorded a provision for income taxes of $8 million on a pre-tax loss from continuing operations of $59 million, yielding an effective tax rate of (13.6)%. This rate differs from the U.S. statutory rate due primarily to the provision for taxes in foreign jurisdictions and the recording of a full valuation allowance against U.S. net deferred tax assets.
Income (loss) from discontinued operations. Loss from discontinued operations was $11 million, or $0.01 per share, for the three months ended June 30, 2003. There was no income (loss) from
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discontinued operations in the current quarter, because we completed our exit of the optoelectronic components business in the prior year.
Nine months ended June 30, 2004 compared to the nine months ended June 30, 2003
The following table shows the change in revenue, both in dollars and in percentage terms by segment:
Nine Months
Ended
June 30, Change
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2004 2003 $ %
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(Dollars in Millions)
Segment Revenue:
Client Systems $ 1,081 $ 940 $ 141 15 %
Infrastructure Systems 392 395 (3 ) (1 )
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Total $ 1,473 $ 1,335 $ 138 10 %
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Revenue. Revenue increased 10% or $138 million, for the nine months ended June 30, 2004, as compared to the same period in 2003. The $141 million revenue increase in the Client segment consists of a $134 million increase in product revenue and a $7 million increase in intellectual property licensing revenue. The product revenue increase was driven primarily by volume increases in the sales of integrated circuits used in mobile phones and hard disk drives. These increases were partially offset by lower revenues in wireless local area networking solutions as we experienced lower demand for our 802.11b solutions. Additionally, we experienced pricing pressure throughout the segment. The revenue decrease of $3 million in the Infrastructure segment is comprised of a $12 million decrease in product revenue partially offset by a $9 million increase in intellectual property licensing revenue. The product revenue decrease was due to a decrease in sales of mature telephony devices and broadband access devices, as demand for older telecommunications-focused products continued to decline. Also, pricing pressure in asynchronous transfer mode applications and volume decreases in physical layer devices resulted in revenue decreases. These decreases were partially offset by volume increases in wireless infrastructure devices, multiservice switching fabrics and network processing devices.
Gross margin. Gross margin increased from 27.3% in the nine months ended June 30, 2003 to 45.3% in the nine months ended June 30, 2004, an increase of 18 percentage points. Gross margin for the Client segment increased to 37.7% in the current period from 15.6% in the prior year period. The Client segment gross margin was positively impacted by improved volume and manufacturing yields, increased manufacturing utilization, and a $66 million decrease in restructuring related costs from the prior year period. These increases were partially offset by price erosion across the entire segment. Gross margin for the Infrastructure segment increased to 66.3% in the current period from 55.2% in the prior year period. The Infrastructure segment margin improvement was due to the combination of improved manufacturing capacity utilization, a $15 million decrease in restructuring related costs, and increased intellectual property revenue.
Selling, general and administrative. Selling, general and administrative expenses decreased 7% or $17 million, from $227 million for the nine months ended June 30, 2003, to $210 million for the nine months ended June 30, 2004. The decrease is due to expense reductions as a result of restructuring actions in information technology, corporate functions and worldwide sales, partially offset by increased bonus accruals for short-term incentive plans.
Research and development. Research and development expenses increased 5% or $18 million, from $360 million for the nine months ended June 30, 2003 to $378 million for the current year period. The increase was due to higher design-related investments and increased headcount in the mobile phone, ethernet, storage and wireless networking areas, and an increase in bonus accruals for short-term incentive plans, partially offset by lower investment in silicon manufacturing process research due to our conversion to a fab-lite business model and lower outside contractor expenses as we moved work to Agere employees.
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Purchased in-process research and development. Purchased in-process research and development expense for the nine months ended June 30, 2004 was $13 million due to our acquisition of TeraBlaze, Inc. in the first quarter of fiscal 2004. There was no purchased in-process research and development expense for the nine months ended June 30, 2003. See Purchased In-Process Research and Development for additional details.
Restructuring and other chargesnet. Net restructuring and other charges . . .
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