UNIVERSAL DISPLAY CORP \PA\ (OLED) FY 2022 MD&A

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 section entitled “Selected Financial Data” in this report and our Consolidated Financial Statements and related notes to this report. This discussion and analysis contains forward-looking statements based on our current expectations, assumptions, estimates and projections. These forward-looking statements involve risks and uncertainties. Our actual results could differ materially from those indicated in these forward-looking statements as a result of certain factors, as more fully discussed in Item 1A of this report, entitled “Risk Factors.”

OVERVIEW

We are a leader in the research, development and commercialization of organic light emitting diode (OLED) technologies and materials for use in display applications, such as mobile phones, televisions, monitors, wearables, tablets, portable media devices, notebook computers, personal computers and automotive applications, as well as specialty and general lighting products. Since 1994, we have been engaged and expect to continue to be primarily engaged, in funding and performing research and development activities relating to OLED technologies and materials, and commercializing these technologies and materials. We derive our revenue primarily from the following:

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sales of OLED materials for evaluation, development and commercial manufacturing;

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intellectual property and technology licensing;

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technology development and support, including third-party collaboration efforts and providing support to third parties for commercialization of their OLED products; and

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contract research services in the areas of chemical materials synthesis research, development and commercialization for non-OLED applications.

Material sales relate to our sale of OLED materials for incorporation into our customers’ commercial OLED products or for their OLED development and evaluation activities. Material sales are generally recognized at the time title passes, which is typically at the time of shipment or at the time of delivery, depending upon the contractual agreement between the parties.

We receive license and royalty payments under certain commercial, development and technology evaluation agreements, some of which are non-refundable advances. These payments may include royalty and license fees made pursuant to license agreements and also license fees included as part of certain commercial supply agreements. These payments are included in the estimate of total contract consideration by customer and recognized as revenue over the contract term based on material units sold at the estimated per unit fee over the life of the contract.

On December 2, 2022, we entered into a commercial patent license agreement with Samsung Display Co., Ltd. (SDC), replacing a previous license agreement that had been in place since 2018. This agreement, which covers the manufacture and sale of specified OLED display materials, was effective as of January 1, 2023 and lasts through the end of 2027 with an additional two-year extension option for SDC. Under this agreement, we are being paid a license fee, which includes quarterly and annual payments over the agreement term of five years. The agreement conveys to SDC the non-exclusive right to use certain of our intellectual property assets for a limited period of time that is less than the estimated life of the assets.

At the same time that we entered into the current commercial license agreement with SDC, we also entered into a material purchase agreement with SDC, which lasts for the same term as the license agreement and is subject to the same extension option. This new material purchase agreement replaced a previous purchase agreement that had been in place since 2018. Under the material purchase agreement, SDC agrees to purchase from us a minimum amount of red and green phosphorescent emitter materials for use in the manufacture of licensed products. This minimum commitment is subject to SDC’s requirements for phosphorescent emitter materials and our ability to meet these requirements over the term of the supplemental agreement.

In 2015, we entered into an OLED patent license agreement and an OLED commercial supply agreement with LG Display Co., Ltd. (LG Display), which were effective as of January 1, 2015. The terms of these agreements were extended by a January 1, 2021 amendment through the end of 2025. The patent license agreement provides LG Display a non-exclusive, royalty bearing portfolio license to make and sell OLED displays under our patent portfolio. The patent license calls for license fees, prepaid royalties and running royalties on licensed products. The OLED commercial supply agreement provides for the sales of materials for use by LG Display, which may include phosphorescent emitters and host materials. The agreements provide for certain other minimum obligations relating to the volume of material sales anticipated over the life of the agreements as well as minimum royalty revenue.

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In 2016, we entered into long-term, multi-year OLED patent license and material purchase agreements with Tianma Micro-electronics Co., Ltd. (Tianma). Under the license agreement, we have granted Tianma non-exclusive license rights under various patents owned or controlled by us to manufacture and sell OLED display products. The license agreement calls for license fees and running royalties on Tianma’s sales of licensed products. Additionally, we supply phosphorescent OLED materials to Tianma for use in its licensed products. In 2021, we mutually agreed to extend the terms of both the patent license and material purchase agreements for an additional multi-year term.

In 2017, we entered into long-term, multi-year agreements with BOE Technology Group Co., Ltd. (BOE). Under these agreements, we have granted BOE non-exclusive license rights under various patents owned or controlled by us to manufacture and sell OLED display products. We also supply phosphorescent OLED materials to BOE for use in its licensed products.

In 2018, we entered into long-term, multi-year OLED patent license and material purchase agreements with Visionox Technology, Inc. (Visionox). Under the license agreement, we have granted certain of Visionox’s affiliates non-exclusive license rights under various patents owned or controlled by us to manufacture and sell OLED display products. The license agreement calls for license fees and running royalties on licensed products. Additionally, we supply phosphorescent OLED materials to Visionox for use in its licensed products. In 2021, we announced an extension of the Visionox agreement by entering into new five-year OLED material supply and license agreements with a new affiliate of Visionox, Visionox Hefei Technology Co. Ltd.

In 2019, we entered into an evaluation and commercial supply relationship with Wuhan China Star Optoelectronics Semiconductor Display Technology Co., Ltd. (CSOT). In 2020, we entered into long-term, multi-year agreements with CSOT. Under these agreements, we have granted CSOT non-exclusive license rights under various patents owned or controlled by us to manufacture and sell OLED display products. We also supply phosphorescent OLED materials to CSOT for use in its licensed products.

In 2016, we acquired Adesis, Inc. (Adesis) which has operations in New Castle and Wilmington, Delaware. Adesis is a contract research organization (CRO) that provides support services to the OLED, pharma, biotech, catalysis and other industries. As of December 31, 2022, Adesis employed a team of 150 research scientists, chemists, engineers and laboratory technicians. Prior to our acquisition of Adesis, we utilized more than 50% of Adesis’ technology service and production output. We continue to utilize a significant portion of its technology research capacity for the benefit of our OLED technology development, and Adesis uses the remaining capacity to operate as a CRO in the above-mentioned industries by providing contract research services for non-OLED applications to those third-party customers. Contract research services revenue is earned by providing chemical materials synthesis research, development and commercialization for non-OLED applications on a contractual basis for those third-party customers.

In June 2020, a wholly-owned subsidiary, OVJP Corporation (OVJP Corp), was formed as a Delaware corporation. Based in California, OVJP Corp was founded to advance the commercialization of our proprietary Organic Vapor Jet Printing (OVJP) technology. As of December 31, 2022, OVJP Corp employed a team of 22 research, mechanical, electrical and software engineers and laboratory technicians. As a direct printing technique, OVJP technology has the potential to offer high deposition rates for large-area OLEDs. In addition, OVJP technology reduces OLED material waste associated with use of a shadow mask (i.e., the waste of material that deposits on the shadow mask itself when fabricating an OLED). By comparison to inkjet printing, an OVJP process does not use liquid solvents and therefore the OLED materials utilized are not limited by their viscosity or solvent solubility. OVJP also avoids generation of solvent wastes and eliminates the additional step of removing residual solvent from the OLED device. We believe the successful implementation of the OVJP technology has the potential to increase the addressable market for large-size OLED panels while also serving another potential growth market for our proprietary PHOLED materials and technologies.

In February 2021, we announced the establishment of a new manufacturing site in Shannon, Ireland and an agreement between UDC Ireland Limited and PPG for the production of our OLED materials. We currently lease the Shannon site and have a contractual option to purchase the facility. When fully operational, the new facility is expected to double our production capacity and allow for the diversification of our manufacturing base for phosphorescent emitters. The first phase of facility improvements has been completed and operations commenced in June 2022.

We also generate technology development and support revenue earned from development and technology evaluation agreements and commercialization assistance fees.

We anticipate fluctuations in our annual and quarterly results of operations due to uncertainty regarding, among other factors:

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the timing, cost and volume of sales of our OLED materials;

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the timing of our receipt of license fees and royalties, as well as fees for future technology development and evaluation;

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the timing and magnitude of expenditures we may incur in connection with our ongoing research and development and patent-related activities; and

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the timing and financial consequences of our formation of new business relationships and alliances.

Further, we continue to monitor the impact of COVID-19 on our business. Our global operations, and the global nature of our customer base and their respective customers, expose us to risks associated with public health crises, such as pandemics, epidemics and disease outbreaks. The ongoing COVID-19 pandemic had a substantial impact on our operations and financial results during the year ended December 31, 2020 and continued to have a gradually lesser impact during the years ended December 31, 2021 and 2022. We expect that as the pandemic continues to evolve, there is the potential for continued impact on the results of our operations due to uncertainties involving the continued disruption of the global economy, uncertainties associated with consumer demand for finished OLED goods, and the potential resulting impact on our customers and their demand for our phosphorescent emitters.

At this time, the crisis has not had a significant impact on our ability to fulfill shipments of commercial materials as required by our customers.

We continue to actively monitor the COVID-19 situation and may take further actions 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 effects any such potential actions could have on our business, including on our customers, employees, and financial results.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based on our Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect our reported assets and liabilities, revenues and expenses, and other financial information. Actual results may differ significantly from our estimates under other assumptions and conditions.

We believe that our accounting policies related to revenue recognition and deferred revenue and income taxes, as described below, are our “critical accounting policies” as contemplated by the SEC. These policies, which have been reviewed with our Audit Committee, are discussed in greater detail below.

Revenue Recognition and Deferred Revenue

Material sales relate to the sale of our OLED materials for incorporation into our customers’ commercial OLED products or for their OLED development and evaluation activities. Revenue associated with material sales is generally recognized at the time title passes, which is typically at the time of shipment or at the time of delivery, depending upon the contractual agreement between the parties. Revenue may be recognized after control of the material passes in the event the transaction price includes variable consideration. For example, a customer may be provided an extended opportunity to stock materials prior to use in mass production and given a general right of return not conditioned on breaches of warranties associated with the specific product. In such circumstances, revenue will be recognized at the earlier of the expiration of the customer’s general right of return or once it becomes unlikely that the customer will exercise its right of return.

The rights and benefits to our OLED technologies are conveyed to the customer through technology license agreements and material supply agreements. We believe that the licenses and materials sold under these combined agreements are not distinct from each other for financial reporting purposes and as such, are accounted for as a single performance obligation. Accordingly, total contract consideration is estimated and recognized over the contract term based on material units sold at the estimated per unit fee over the life of the contract. Total contract consideration is allocated to material sales and royalty and licensing fees on the Consolidated Statements of Income based on contract pricing.

Various estimates are relied upon to recognize revenue. We estimate total material units to be purchased by our customers over the contract term based on historical trends, industry estimates and our forecast process. Our management uses the expected value method to estimate the material per unit fee. Additionally, our management estimates the sales-based portion of royalty revenue based on the estimated net sales revenue of our customers over the contract term.

Accounting for Income Taxes

We are subject to income taxes in both the U.S. and foreign jurisdictions. Significant judgments and estimates are required in evaluating our tax positions for future realization and determining our provision for income taxes. Our income tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management's best assessment of estimated future taxes to be paid.

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In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of our deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent on our ability to generate future taxable income to obtain benefit from the reversal of temporary differences, net operating loss carryforwards and tax credits. As part of our assessment, we consider the scheduled reversal of deferred tax assets and liabilities, projected future taxable income, and tax planning strategies.

During the year ended December 31, 2022, based on our previous earnings history, a current evaluation of expected future taxable income and other evidence, we determined to retain the valuation allowance that relates to New Jersey research and development credits and unrealized loss on investments. Actual results could differ from our assessments if adequate taxable income is generated in future periods. To the extent we establish a new valuation allowance or change a previously established valuation allowance in a future period, income tax expense will be impacted.

RESULTS OF OPERATIONS

For a discussion of our results of operations comparison for the years ended December 31, 2021 and 2020, refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2021 filed on February 23, 2022.

Comparison of the Years Ended December 31, 2022 and 2021

Revenue

Our total material sales were $331.1 million for the year ended December 31, 2022, as compared to $318.6 million for the year ended December 31, 2021, an increase of 4% with a commensurate increase in unit material volume of 4%.

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Green emitter sales for the year ended December 31, 2022, which include our yellow-green emitters, were $251.6 million as compared to $242.9 million for the year ended December 31, 2021, with unit material volumes increasing by 3%.

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Red emitter sales for the year ended December 31, 2022, were $79.0 million as compared to $75.2 million for the year ended December 31, 2021, with unit material volumes increasing by 8%.

Revenue from royalty and license fees was $267.1 million for the year ended December 31, 2022 as compared to $219.0 million for the year ended December 31, 2021, an increase of 22%. This increase was primarily the result of a favorable cumulative catch-up adjustment arising from changes in estimates of transaction price and higher unit material volume.

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The cumulative catch-up adjustment arising from changes in estimates of transaction price, net was $30.3 million for the year ended December 31, 2022 resulted from an increase in the average price per gram that was primarily due to the decrease in anticipated demand by several of our customers over the remaining lives of their contracts, resulting from the continued deterioration in the global market economy as evidenced by weakness in consumer demand caused by higher interest rates and inflationary pricing pressures. At this time, substantial uncertainty exists as to the projected duration and intensity of this global market deterioration and the extent to which it will negatively impact such customers' near-term production requirements.

Contract research services revenue was $18.4 million for the year ended December 31, 2022 as compared to $15.9 million for the year ended December 31, 2021, an increase of 16%. Revenue from contract research services consists of revenue earned by our subsidiary, Adesis, which provides support services to the pharma, biotech, catalysis and other industries on a contractual basis for those third-party customers.

Cost of Sales

Cost of sales for the year ended December 31, 2022 increased by $12.9 million as compared to the year ended December 31, 2021, primarily due to an increase in the level of material sales with an associated increase in manufacturing costs, underutilization of the manufacturing facility in Shannon, Ireland and higher per unit material costs. The underutilization charges related to the Shannon facility were $7.9 million for the year ended December 31, 2022. Shannon facility charges began to be recorded as cost of sales in June 2022 when the facility was first used for production activities. Shannon facility costs prior to June 2022 were recorded in selling, general and administrative expenses. We anticipate that the Shannon facility will continue to be underutilized in the near-term as we have begun to bring this additional capacity online in preparation for anticipated growth in the years ahead. Included in the cost of sales for both fiscal years ended December 31, 2022 and 2021 was an increase in inventory reserve of $3.6 million due to excess inventory levels in certain products. As a result of the increase in revenue from royalty and license fees and material sales, gross margin for the year ended December 31, 2022 increased by $50.2 million as compared to the year ended December 31, 2021, with gross margin as a percentage of revenue remaining consistent at 79%.

Research and development

Research and development expenses increased to $117.1 million for the year ended December 31, 2022, as compared to $99.7 million for the year ended December 31, 2021. The increase in research and development expenses was primarily due to increased contract research and PPG development activity, higher employee-related compensation expenses and operating costs, including those associated with OVJP technology development.

Selling, general and administrative

Selling, general and administrative expenses decreased to $77.9 million for the year ended December 31, 2022, as compared to $80.4 million for the year ended December 31, 2021. The decrease in selling, general and administrative expenses was primarily due to lower stock-based compensation, partially offset by increased pre-production costs associated with the Shannon facility, an increase in depreciation expense resulting from corporate expansion, as well as an increase in overall general office expenses.

Amortization of acquired technology and other intangible assets

Amortization of acquired technology and other intangible assets was $17.5 million for the year ended December 31, 2022, as compared to $22.0 million for the year ended December 31, 2021. The decrease was due to the Fujifilm patents becoming fully amortized during the year ended December 31, 2022. See Note 7 in Notes to Consolidated Financial Statements for further discussion.

Patent costs

Patent costs increased to $8.3 million for the year ended December 31, 2022, as compared to $8.2 million for the year ended December 31, 2021.

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Royalty and license expense

Royalty and license expense increased to $877,000 for the year ended December 31, 2022, as compared to $691,000 for the year ended December 31, 2021.

Interest and other (loss) income, net

Interest income, net was $7.8 million for the year ended December 31, 2022, as compared to $505,000 for the year ended December 31, 2021. The increase in interest income, net was primarily due to an increase in bond yields on available-for-sale investments held during the year ended December 31, 2022 compared to the prior year as well as higher available-for-sale investment balances. Other (loss) income, net primarily consisted of impairment of minority investments of $7.0 million during the year ended December 31, 2022, net exchange gains and losses on foreign currency transactions and rental income. We recorded other loss, net of $6.7 million for the year ended December 31, 2022 as compared to other income, net of $98,000 for the year ended December 31, 2021.

Income tax expense

We are subject to income taxes in both the United States and foreign jurisdictions. The effective income tax rate was an expense of 21.7% and 19.3% for the years ended December 31, 2022 and 2021, respectively, and we recorded income tax expense of $58.2 million and $44.0 million, respectively, for those periods. The effective income tax rate increased due to a change in U.S. tax legislation associated with the ability to credit Chinese withholding taxes, as well as the impact to the global intangible low-taxed income (GILTI) arising from a change in the capitalization rules for research and development expenses.

Liquidity and Capital Resources

Our principal sources of liquidity are our cash and cash equivalents and short-term investments. As of December 31, 2022, we had cash and cash equivalents of $93.4 million, short-term investments of $484.3 million, and long-term corporate bond and U.S. Government bond investments of $247.9 million for a total of $825.6 million. This compares to cash and cash equivalents of $312.0 million, short-term investments of $351.2 million, and long-term U.S. Government bond investments of $159.6 million for a total of $822.8 million as of December 31, 2021.

Cash provided by operating activities for the year ended December 31, 2022 was $126.8 million resulting from $210.1 million of net income and an increase of $51.0 million due to non-cash items including stock-based compensation, depreciation, amortization of intangibles and deferred income taxes, partially offset by a $134.3 million reduction due to changes in our operating assets and liabilities. Changes in our operating assets and liabilities related to a decrease in deferred revenue of $93.2 million, an increase in inventory of $49.1 million and a decrease in other liabilities of $11.4 million, partially offset by a decrease in accounts receivable of $15.0 million, an increase in accounts payable and accrued expenses of $3.3 million and a decrease in other assets of $1.1 million.

Cash provided by operating activities for the year ended December 31, 2021 was $191.1 million resulting from $184.2 million of net income and an increase of $88.5 million due to non-cash items including stock-based compensation, amortization of intangibles and depreciation, partially offset by a $81.6 million reduction due to changes in our operating assets and liabilities. Changes in our operating assets and liabilities related to an increase in inventory of $42.6 million, an increase in other assets of $32.6 million, an increase in accounts receivable of $25.4 million and a decrease in deferred revenue of $5.2 million, partially offset by an increase in other liabilities of $22.3 million and an increase in accounts payable and accrued expenses of $1.9 million.

Cash used in investing activities was $280.7 million for the year ended December 31, 2022, as compared to $457.8 million for the year ended December 31, 2021. The decrease was due to the timing of maturities and purchases of investments resulting in net purchases of $233.5 million for the year ended December 31, 2022, as compared to $414.2 million for the year ended December 31, 2021, partially offset by an increase in purchases of intangibles and property, plant and equipment of $3.6 million for the year ended December 31, 2022 as compared to the year ended December 31, 2021. The increase in intangible purchases during the year ended December 31, 2022 was primarily due to a patent purchase. The increase in property, plant and equipment purchases during the year ended December 31, 2022 was primarily due to the manufacturing facility in Shannon, Ireland and improvements to our facilities in Ewing, New Jersey.

Cash used in financing activities was $64.6 million for the year ended December 31, 2022, as compared to $51.4 million for the year ended December 31, 2021. The increase was due to an increase in the cash payment of dividends in the current year of $19.0 million, partially offset by a decrease in the payment of withholding taxes related to stock-based compensation to employees of $5.7 million and an increase in the proceeds from issuance of common stock of $63,000.

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Working capital was $763.8 million as of December 31, 2022, as compared to $738.0 million as of December 31, 2021. The increase was primarily due to an increase in short-term investments, a decrease in deferred revenue and an increase in inventory, partially offset by decreases in cash and cash equivalents.

Several significant contractual obligations are anticipated to be incurred in future periods and include payments for retirement benefit plan obligations, lease obligations and PPG inventory commitments. Payments towards the retirement plan obligations will commence during fiscal year 2023 in the amount of $2.0 million and are expected to total $93.1 million over the life of the plan. Existing lease obligations are $4.6 million for fiscal year 2023, $9.3 million in total for fiscal years 2023 and 2024 and $21.6 million thereafter. Existing PPG inventory commitments are $31.9 million and will fluctuate based on PPG production needs to fulfill to our demand for commercial emitter material.

We anticipate, based on our internal forecasts and assumptions relating to our operations (including, among others, assumptions regarding our working capital requirements, the progress of our research and development efforts, the availability of sources of funding for our research and development work, and the timing and costs associated with the preparation, filing, prosecution, maintenance, defense and enforcement of our patents and patent applications), that we have sufficient cash, cash equivalents and short-term investments to meet our obligations for at least the next twelve months. However, the extent to which the COVID-19 pandemic and our precautionary measures in response thereto may impact our business and thus our liquidity will depend on future developments, which are highly uncertain and cannot be precisely estimated at this time.

We believe that potential additional financing sources for us include long-term and short-term borrowings and public and private sales of our equity and debt securities. It should be noted, however, that additional funding may be required in the future for research, development and commercialization of our OLED technologies and materials, to obtain, maintain and enforce patents respecting these technologies and materials, and for working capital and other purposes, the timing and amount of which are difficult to ascertain. There can be no assurance that additional funds will be available to us when needed, on commercially reasonable terms or at all, particularly in the current economic environment.

Recently Issued Accounting Pronouncements

Recently issued accounting pronouncements are addressed in Note 2 in the Notes to Consolidated Financial Statements.