Credo Technology Group Holding Ltd (CRDO) FY 2024 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed in those forward-looking statements. Factors that could cause or contribute to such differences include those identified below and those discussed in the section titled “Risk Factors.”
A discussion regarding our financial condition and our results of operations for the fiscal year ended April 27, 2024 compared to the fiscal year ended April 29, 2023 is presented below. A discussion regarding our results of operations for the fiscal year ended April 29, 2023 compared to the fiscal year ended April 30, 2022 can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended April 29, 2023, filed with the SEC on June 23, 2023.
Overview
Credo provides innovative, secure, high-speed and power-efficient connectivity solutions. Our solutions target the data infrastructure market, where bandwidth requirements are increasing exponentially, driven by the accelerating deployment of leading edge Artificial Intelligence infrastructure and applications. Our connectivity solutions are optimized for optical and electrical Ethernet applications, including the 100G (or Gigabits per second), 200G, 400G, 800G and emerging 1.6T (or Terabits per second) markets. Our products are based on our Serializer/Deserializer (SerDes) and Digital Signal Processor (DSP) technologies. Our product families include integrated circuits (ICs), Active Electrical Cables (AECs) and SerDes Chiplets. Our intellectual property (IP) solutions consist primarily of SerDes IP licensing.
Data generation has increased dramatically over the past ten years, creating new and complicated challenges in both circuit and system design. Our proprietary SerDes and DSP technologies enable us to achieve similar performance to leading competitors’ products but at a lower cost and more highly available legacy node (n-1 advantage). Beyond power and performance, Credo continues to innovate to address customers’ system level requirements. We partner with Microsoft on our HiWire Switch AEC and open-source implementation that helps realize Microsoft’s vision for a highly reliable network-managed dual-Top-of-Rack (ToR) architecture (a network architecture design in which computing equipment located within the same or an adjacent rack are, for redundancy, connected to two in-rack network switches, which are, in turn, connected to aggregation switches via fiber optic cables), overcome complex and slow legacy enterprise approaches, simplify deployment and improve connection reliability in the data center.
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The multibillion-dollar data infrastructure market that we serve is driven largely by hyperscale data centers (hyperscalers), as well as general compute, AI/ML infrastructure, multi-service operators (MSOs), and mobile network operators (MNOs). The demands for increased bandwidth, improved power and cost efficiency and heightened security have simultaneously and dramatically expanded as work, education and entertainment have rapidly digitized across myriad endpoint users.
We design, market and sell both product and IP solutions. We help define industry conventions and standards within the markets we target by collaborating with technology leaders and standards bodies. We contract with a variety of manufacturing partners to build our products based on our proprietary SerDes and DSP technologies. We develop standard solutions we can sell broadly to our end markets and also develop tailored solutions designed to address specific customer needs. Once developed, these tailored solutions can generally be broadly leveraged across our portfolio and we are able to sell the part or license the IP to the broader market.
During fiscal 2024 and 2023, we generated $193.0 million and $184.2 million in total revenue, respectively. Product sales and product engineering services revenue comprised 85% and 83% of our total revenue in fiscal 2024 and 2023, respectively, and IP license and IP license engineering services revenue represented 15% and 17% of our total revenue in fiscal 2024 and 2023, respectively. Geographically, 31% of our total revenue in both fiscal 2024 and 2023 was generated from customers in North America, and 69% of our total revenue in both fiscal 2024 and 2023 was generated from customers in the rest of the world, primarily in Asia. During fiscal 2024 and 2023, we generated $28.4 million and $16.5 million of net loss, respectively.
We derive the substantial majority of our revenue from a limited number of customers. We anticipate we will continue to derive a significant portion of our revenue from a limited number of customers for the foreseeable future. We expect that as our products are more widely adopted and as our number of customers increase, customer concentration will decrease.
We sell our products to hyperscalers, original equipment manufacturers (OEMs), original design manufacturers (ODMs) and optical module manufacturers, as well as to companies in the enterprise and HPC markets. We work closely and have engagements with industry-leading companies across these segments. A relatively small number customers have historically accounted for and continue to account for a significant portion of our revenue. We report revenue by customer in our financial statement disclosure based on the contracting parties who place purchase orders or sign revenue contracts with us. See Note 3 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. However, certain of our end customers have their contract manufacturing partners place orders with us. As a result, the contract manufacturers, rather than the end customers, are reported as our customers for financial reporting purposes. As a supplement to our financial statement footnote disclosure, and to provide further insight into our end customer concentration, the following table summarizes our revenue by customer as a percentage of total revenue based on end customer profile, rather than based on the contracting parties who place purchase orders or sign revenue contracts with us:
| Year Ended | |||||
|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | ||||
| Revenue: | |||||
| Customer Z | 26 | % | 55 | % | |
| Customer Y | 20 | % | * | ||
| Customer B | 15 | % | * | ||
| Customer C | * | 12 | % | ||
| Customer E | * | 13 | % |
* Less than 10% of total revenue.
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Our Business Model
We are a product-focused business with a strong foundation in IP, pioneering comprehensive connectivity solutions that deliver bandwidth, scalability, and end-to-end signal integrity for next-generation platforms. We also develop IP solutions to address the specific and complex needs of our customers. We earn revenue from these IP solutions primarily through licensing fees and royalties. In addition to product sales and IP license revenue, we also generated revenue from providing engineering services as part of our product and license arrangements with certain customers. Over time, we expect to generate an increased proportion of our revenue from sales of our products. We expect to see a long-term benefit from improvements in our operating leverage as our business continues to gain scale.
We utilize a fabless business model, working with a network of third parties to manufacture, assemble and test our connectivity products. This approach allows us to focus our engineering and design resources on our core competencies and to control our fixed costs and capital expenditures.
We employ a two-pronged sales strategy targeting both the end users of our products, as well as the suppliers of our end users. By engaging directly with the end user, we are able to better understand the needs of our customers and cater our solutions to their most pressing connectivity requirements.
This strategy has enabled us to become the preferred vendor to a number of our customers who, in turn, in some cases, require their suppliers, OEMs, ODMs and optical module manufacturers to utilize our solutions.
Components of Our Operating Results
Revenue
Our revenues consist of sale of our products, licensing of and providing engineering services related to our IP and providing product engineering services. Product sales primarily consists of shipment of our ICs and AEC products. IP license revenue includes fees from licensing of our SerDes IP and related engineering and support fees and royalties. Product engineering consists of engineering fees associated with integration of our technology solutions into our customers’ products. Our customers are primarily OEMs who design and manufacture end market devices for the communications and enterprise networks markets. Our revenue is driven by various trends in these markets. Our revenue is also impacted by changes in the number and average selling prices of our IC products.
We recognize revenue upon transfer of control of promised goods and services in an amount that reflects the consideration we expect to receive in exchange for those goods and services. Where an arrangement includes multiple performance obligations, the transaction price is allocated to these on a relative standalone selling price (SSP) basis. We determine the SSP based on an observable standalone selling price when it is available, as well as other factors, including the price charged to customers and our overall pricing objectives, while maximizing observable inputs. When SSPs are not directly observable, we use the adjusted market assessment approach or residual approach, if applicable. We also consider the constraint on estimates of variable consideration when estimating the total transaction price. Our policy is to record revenue net of any applicable sales, use or excise taxes. Changes in our contract assets and contract liabilities primarily result from the timing difference between our performance and the customer’s payment. We fulfill our obligations under a contract with a customer by transferring products or services in exchange for consideration from the customer. We recognize a contract asset when we transfer products or services to a customer and the right to consideration is conditional on something other than the passage of time. Accounts receivable are recorded when the customer has been billed or the right to consideration is unconditional. We recognize deferred revenue when we have received consideration or an amount of consideration is due from the customer and we have a future obligation to transfer products or services.
Product Sales - We transact with customers primarily pursuant to standard purchase orders for delivery of products and generally allow customers to cancel or change purchase orders within limited
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notice periods prior to the scheduled shipment date. We offer standard performance warranties of twelve months after product delivery and offer limited product return rights to certain distributors. We recognize product sales when we transfer control of promised goods in an amount that reflects the consideration to which we expect to be entitled to in exchange for those goods, net of accruals for estimated sales returns and rebates.
Product Engineering Services Revenue - Some product revenue contracts include non-recurring engineering services deliverables. We recognize revenue from these agreements over time as services are provided or at a point in time upon completion and acceptance by the customer of contract deliverables, depending on the terms of the arrangement. Revenue is deferred for any amounts billed or received prior to delivery of services. We believe the input method, based on time spent by our engineers, best depicts the efforts expended to transfer services to the customers.
IP License Revenue - Our IP license revenue consists of perpetual licenses, support and maintenance, engineering services and royalties. We enter into perpetual semiconductor IP license agreements that have a fixed fee, whereby licensees pay a fixed fee for the right to incorporate our IP technologies into the licensee’s products. The IP license agreements do not typically grant the customer the right to terminate for convenience. Where such rights exist, termination is prospective, with no refund of fees already paid by the customer.
IP revenue recognition is dependent on the nature and terms of each agreement. We recognize IP license revenue at the point of time of the delivery of the IP. In connection with the license arrangements, we offer support to assist customers in qualifying their final product. Revenue from customer support is deferred and recognized ratably over the support period, which is typically one year. Some IP license revenue contracts also include non-recurring engineering services deliverables, which were not material for any of the periods presented. We recognize revenue from these agreements similar to the method described under the caption “Product Engineering Services Revenue” above.
In certain cases, we also charge licensees royalties related to the distribution or sale of products that use our technologies. Such royalties are reported to us on a quarterly basis. We estimate the sales-based royalties earned each quarter primarily based on our customers’ reporting of sales activity incurred in that quarter. We recognize the estimated royalty revenue when it is probable that reversal of such amounts will not occur. Any differences between actual royalties owed by a customer and the quarterly estimates are recognized when updated information becomes available.
Cost of Revenue
Cost of revenue includes cost of materials, such as wafers processed by third-party foundries, cost associated with packaging and assembly, testing and shipping, cost of personnel, including share-based compensation, depreciation of equipment associated with manufacturing support, logistics and quality assurance, warranty cost, amortization of intellectual property purchased from third parties, write-down of inventories and amortization of production mask costs. Costs of revenue includes cost of product sales revenue, cost of product engineering services revenue and cost of IP license revenue.
Research and Development Expenses
Research and development expenses consist of costs incurred in performing research and development activities and includes salaries, share-based compensation, employee benefits, occupancy costs, pre-production engineering mask costs, overhead costs and prototype wafer, packaging and test costs. Research and development costs are expensed as incurred.
We believe that continued investments in our products are important to our future growth and, as a result, we expect our research and development expenses to continue to increase in absolute dollars.
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Selling, General and Administrative Expenses
Selling expenses consist of personnel costs including salaries, benefits and share-based compensation expense, field application engineering support, samples to customers, shipping costs and travel and entertainment costs.
General and administrative expenses consist primarily of personnel costs including salaries, benefits, and share-based compensation, related to corporate, finance, legal and human resource functions, contractor and professional services fees, audit and compliance expenses, insurance costs, and general corporate expenses including allocated facilities expenses.
Impairment Charges
Impairment charges consist primarily of impairment on property and equipment for assets no longer in service.
Other Income and Expense, Net
Other income and expense, net consists primarily of interest income from significant financing components related to IP license revenue contracts, and foreign exchange gains and losses.
Provision for Income Taxes
Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. Under this method, deferred income tax assets and liabilities are determined based on differences between the financial statement reporting and tax bases of assets and liabilities and net operating loss and credit carryforward. Deferred tax assets and liabilities are measured using enacted tax rates applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized.
We account for uncertain tax positions in accordance with ASC 740‑10, Accounting for Uncertainty in Income Taxes. We recognize the tax effects of an uncertain tax position only if it is more likely than not to be sustained based solely on its technical merits as of the reporting date and only in an amount more likely than not to be sustained upon review by the tax authorities. Interest and penalties related to uncertain tax positions are classified in the consolidated financial statements as income tax expense.
Results of Operations
Years Ended April 27, 2024 and April 29, 2023
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The following table sets forth information derived from our consolidated statements of operations expressed as a percentage of total revenue:
| Year Ended | |||||
|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | ||||
| Revenue: | |||||
| Product sales | 75.2 | % | 76.8 | % | |
| Product engineering services | 10.3 | % | 5.9 | % | |
| IP license | 14.5 | % | 17.3 | % | |
| Total revenue | 100.0 | % | 100.0 | % | |
| Cost of revenue: | |||||
| Cost of product sales revenue | 36.5 | % | 40.8 | % | |
| Cost of product engineering services revenue | 1.2 | % | 0.5 | % | |
| Cost of IP license revenue | 0.4 | % | 1.0 | % | |
| Total cost of revenue | 38.1 | % | 42.3 | % | |
| Gross margin | 61.9 | % | 57.7 | % | |
| Operating expenses: | |||||
| Research and development | 49.5 | % | 41.7 | % | |
| Selling, general and administrative | 31.2 | % | 26.2 | % | |
| Impairment charges | 0.4 | % | 1.3 | % | |
| Total operating expenses | 81.1 | % | 69.2 | % | |
| Operating loss | (19.2) | % | (11.5) | % | |
| Other income (expense), net | 7.4 | % | 1.8 | % | |
| Loss before income taxes | (11.8) | % | (9.7) | % | |
| Provision (benefit) for income taxes | 2.9 | % | (0.7) | % | |
| Net loss | (14.7) | % | (9.0) | % |
Comparison of Years Ended April 27, 2024 and April 29, 2023
Revenue
| Year Ended | % Change | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | |||||||||
| (in thousands, except percentages) | ||||||||||
| Product sales | $ | 145,048 | $ | 141,475 | 2.5 | % | ||||
| Product engineering services | 19,898 | 10,780 | 84.6 | % | ||||||
| IP license | 28,024 | 31,939 | (12.3) | % | ||||||
| Total revenue | $ | 192,970 | $ | 184,194 | 4.8 | % |
Revenue for fiscal 2024 increased by $8.8 million primarily due to increases in product engineering services revenue of $9.1 million.
The increase in product engineering services revenue was primarily due to Credo entering into two new non-recurring engineering contracts, one of which was entered into in fiscal 2024 and which saw significant ramp-up in the year, resulting in revenue recognition of $15.5 million.
The increase in product sales revenue was driven by growth in Chiplet and Optical products, offset by a modest decline in AEC products. As a result, the product mix was more diverse in fiscal 2024 than in fiscal 2023.
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Cost of Revenue
| Year Ended | % Change | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | |||||||||
| (in thousands, except percentages) | ||||||||||
| Cost of product sales revenue | $ | 70,498 | $ | 75,143 | (6.2) | % | ||||
| Cost of product engineering services revenue | 2,225 | 972 | 128.9 | % | ||||||
| Cost of IP license revenue | 816 | 1,885 | (56.7) | % | ||||||
| Total cost of revenue | $ | 73,539 | $ | 78,000 | (5.7) | % |
Cost of revenue decreased by $4.5 million primarily due to $4.6 million decrease in cost of product sales revenue. The decrease was driven by improvement of our product sales gross margin from 46.9% in fiscal 2023 to 51.4% in fiscal 2024 as a result of increased product sales that drove the economies of scales.
Gross Profit and Gross Margin
| Year Ended | % Change | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | |||||||||
| (in thousands, except percentages) | ||||||||||
| Gross profit | $ | 119,431 | $ | 106,194 | 12.5 | % | ||||
| Gross margin | 61.9 | % | 57.7 | % |
Gross margin increased by 4.2 percentage points in fiscal 2024 primarily driven by (a) an increase in our high-margin product engineering services revenue as a percentage of overall revenue; and (b) an increase of product sales gross margin as noted above.
Research and Development
| Year Ended | % Change | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | |||||||||
| (in thousands, except percentages) | ||||||||||
| Research and development | $ | 95,531 | $ | 76,774 | 24.4 | % | ||||
| % of total revenue | 49.5 | % | 41.7 | % |
Research and development expenses for fiscal 2024 increased by $18.8 million compared to fiscal 2023. The increase was due primarily to a $7.0 million increase in personnel costs primarily as a result of new hires for product development, an $8.0 million increase in share-based compensation expense driven by increased amortization expense from new equity awards granted to employees, a $2.2 million increase in depreciation expense driven by increased computer equipment and software and laboratory equipment utilized in research and development activities, and a $1.5 million increase in information technology and facilities costs.
Selling, General and Administrative
| Year Ended | % Change | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | |||||||||
| (in thousands, except percentages) | ||||||||||
| Selling, general and administrative | $ | 60,193 | $ | 48,248 | 24.8 | % | ||||
| % of total revenue | 31.2 | % | 26.2 | % |
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Selling, general and administrative expenses for fiscal 2024 increased by $11.9 million compared to the same period in fiscal 2023. The increase was due primarily to a $2.6 million increase in personnel costs as a result of higher selling, general and administrative headcount, a $7.0 million increase in share-based compensation expense driven by increased amortization expense from new equity awards granted to employees, a $1.1 million increase in legal expenses and a $0.6 million increase in software licenses.
Impairment Charges
| Year Ended | % Change | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | |||||||||
| (in thousands, except percentages) | ||||||||||
| Impairment charges | $ | 765 | $ | 2,407 | (68.2) | % | ||||
| % of total revenue | 0.4 | % | 1.3 | % |
Impairment charges incurred in fiscal 2024 and 2023 were primarily related to the impairments on property and equipment, and third-party IP license that did not reach production qualification.
Provision (benefit) for Income Taxes
| Year Ended | % Change | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | |||||||||
| (in thousands, except percentages) | ||||||||||
| Provision (benefit) for income taxes | $ | 5,624 | $ | (1,367) | (511.4) | % | ||||
| % of total revenue | 2.9 | % | (0.7) | % |
Provision for income taxes in fiscal 2024 increased by $7.0 million compared to the same period in fiscal 2023. The increase was primarily due to the establishment of a full valuation allowance to offset U.S. deferred tax assets in fiscal 2024.
Liquidity and Capital Resources
Our activities consist primarily of selling our products, licensing our IP, providing IP customization services and conducting research and development of our products and technology. As of April 27, 2024 and April 29, 2023, we had cash and cash equivalents of $66.9 million and $108.6 million, respectively, and working capital of $485.6 million and $297.2 million, respectively. Our principal use of cash is to fund our operations and invest in research and development to support our growth. See also Note 7 to our consolidated financial statements included in this Annual Report on Form 10-K for a further discussion of our cash requirements under non-cancelable purchase obligations.
We believe our existing cash and cash equivalents and other components of working capital will be sufficient to meet our needs for at least the next 12 months and in 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, customer demand and the continuing market acceptance of our solutions. In the event that we need to borrow funds or issue additional equity, we cannot be assured 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, our business, results of operations and financial condition would be adversely affected.
The following table summarizes our cash flows for the periods indicated.
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| Year Ended | ||||||
|---|---|---|---|---|---|---|
| April 27, 2024 | April 29, 2023 | |||||
| (in thousands) | ||||||
| Net cash provided by (used in) operating activities | $ | 32,737 | $ | (24,615) | ||
| Net cash used in investing activities | $ | (249,485) | $ | (130,941) | ||
| Net cash provided by financing activities | $ | 175,276 | $ | 4,885 |
Cash Flows Provided by (Used in) Operating Activities
Net cash provided by operating activities was $32.7 million for fiscal 2024. The cash inflows from operating activities for fiscal 2024 were primarily due to a net loss of $28.4 million adjusted for the following non-cash items: share-based compensation expense of $39.0 million, depreciation and amortization of $13.8 million, and other non-cash items of $9.0 million. This was offset by $0.7 million of cash outflows for working capital purposes. The cash outflows from working capital for fiscal 2024 were primarily driven by (a) an increase in accounts receivable of $10.1 million primarily due to increased sales in the fiscal 2024 compared to fiscal 2023 and timing of collection; (b) and an increase in contract assets of $12.1 million primarily driven by certain IP licensing and engineering services arrangements where certain billing milestones had not yet been reached but the criteria for revenue had been met. This was offset by a decrease in inventory of $15.8 million primarily driven by tightened production management and increased product sales compared to fiscal 2023.
Net cash used in operating activities was $24.6 million for fiscal 2023. The cash outflows from operating activities for fiscal 2023 were primarily due to $16.5 million of net loss and $50.4 million of cash outflows for working capital purposes, partially offset by $42.4 million of non-cash items. The cash outflows from working capital for fiscal 2023 were primarily driven by (a) an increase in accounts receivable of $20.0 million primarily due to increased sales in the fiscal 2023 compared to fiscal 2022 and timing of collection; (b) an increase in inventory of $24.4 million to better support unfulfilled backlog and related new product ramps; (c) and an increase in contract assets of $1.6 million primarily driven by certain IP licensing and engineering services arrangements where certain billing milestones had not yet been reached but the criteria for revenue had been met. This was offset by increases in accounts payable of $3.8 million and accrued expenses, compensation and other liabilities of $0.5 million due to amounts payable relating to increased purchases of inventory to support growing demand for our products.
Cash Flows Used in Investing Activities
Net cash used in investing activities of $249.5 million in fiscal 2024 was attributable to purchases of property and equipment of $15.7 million and investments in certificates of deposit of $169.8 million, partially offset by maturities of investment in certificates of deposit of $403.6 million. Purchases of property and equipment primarily relate to mask sets purchases for new products introduced or in process of being introduced, and computer equipment and software used for research and development purposes.
Net cash used in investing activities of $130.9 million in fiscal 2023 was attributable to purchases of property and equipment of $21.7 million and investment in certificates of deposit of $159.2 million, partially offset by maturities of investment in certificates of deposits of $50.0 million. Purchases of property and equipment primarily relate to mask sets purchases for new products introduced or in process of being introduced, and computer equipment and software used for research and development purposes.
Cash Flows Provided by Financing Activities
Net cash provided by financing activities of $175.3 million for fiscal 2024 was primarily attributable to $173.4 million proceeds from issuance of ordinary shares in connection our follow-on public offering, net of offering costs, $7.1 million in proceeds from exercises of employee share options and the issuance of
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shares under our employee share purchase plan, offset by $3.1 million in payments for long-term technology license obligations.
Net cash provided by financing activities of $4.9 million in fiscal 2023 was primarily attributable to $5.5 million in proceeds from exercises of employee share options and the issuance of shares under our employee share purchase plan.
Critical Accounting Estimates
We prepare our financial statements in conformity with GAAP. The preparation of financial statements in accordance with GAAP requires certain estimates, assumptions and judgments to be made that may affect our consolidated financial statements. Accounting policies that have a significant impact on our results are described in Note 2 to our consolidated financial statements included elsewhere in this filing. The accounting policies discussed in this section are those that we consider to be the most critical. We consider an accounting policy to be critical if the policy is subject to a material level of judgment and if changes in those judgments are reasonably likely to materially impact our results.
We base our estimates and judgments on our historical experience, knowledge of current conditions, and our beliefs of what could occur in the future, given the available information. Estimates are used for, but not limited to, write-down for excess and obsolete inventories, the SSP for each distinct performance obligation included in customer contracts with multiple performance obligations, variable consideration from revenue contracts, determination of the fair value of share awards and customer warrant, valuation of ordinary shares and the realization of tax assets and estimates of tax reserves. Actual results may differ from those estimates and such differences may be material to the financial statements.
We continue to monitor and assess our critical estimates in light of developments, and as events continue to evolve and additional information becomes available, our estimates may change materially in future periods.
Revenue Recognition
We recognize revenue upon transfer of control of promised goods and services in an amount that reflects the consideration we expect to receive in exchange for those goods and services. Where an arrangement includes multiple performance obligations, the transaction price is allocated to these on a relative standalone selling price (SSP) basis. We determine the SSP based on an observable standalone selling price when it is available, as well as other factors, including the price charged to customers and our overall pricing objectives, while maximizing observable inputs. The determination of the SSP for certain of our IP requires an estimate of the fair value under the income approach, involving the estimation of future cash flow expected to be generated from the IP. Our policy is to record revenue net of any applicable sales, use or excise taxes.
We transact with customers primarily pursuant to standard purchase orders for delivery of products and generally allow customers to cancel or change purchase orders within limited notice periods prior to the scheduled shipment date. We offer standard performance warranties of twelve months after product delivery and offer limited product return rights to certain distributors, other than returns due to warranty issues. We recognize product sales when we transfer control of promised goods in an amount that reflects the consideration to which we expect to be entitled in exchange for those goods, net of accruals for estimated sales returns and rebates.
We account for the warrant issued to Amazon.com NV Investment Holdings LLC as an equity instrument, based on the specific terms of the warrant agreement. We analyze the probability of vesting of each tranche of the warrant based on the demand forecast from the customer. When we determine that it is probable that a tranche of the warrant will vest and we recognize the related revenue, the grant date
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fair value of the associated tranche will be recognized in shareholders’ equity and the underlying expense will be amortized as a reduction of revenue in proportion to the amount of related revenue recognized.
Inventory Valuation
We value our inventory, which includes raw materials, assembly and test, and other manufacturing costs, at the lower of cost and net realizable value. Cost is computed using standard cost, which approximates actual cost, on a first-in, first-out basis. Net realizable value is the estimated selling price of our products in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. We regularly review inventory quantities on hand and non-cancellable purchase commitments, and record write-downs for excess and obsolete inventory based primarily on the shipment history and our estimated forecast of product demand. These factors are impacted by market and economic conditions, technology changes, new product introductions and changes in strategic direction. If the future demand for our products is less favorable than our forecasts, the value of the inventories may be required to be reduced, which could result in additional expense to us and affect our results of operations. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions that we use to calculate our inventory reserve. However, if estimates regarding customer demand are inaccurate or changes in technology affect demand for certain products in an unforeseen manner, we may be exposed to losses or gains that could be material.
Recent Accounting Pronouncements
For more information, see Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.