Lattice Semiconductor Corp: Form 10-Q for the period ended Mar 28, 2020

The following discussion should be read along with the unaudited consolidated financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q, as well as the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2019 10-K.

Overview

Lattice Semiconductor Corporation and its subsidiaries (“Lattice,” the “Company,” “we,” “us,” or “our”) develop technologies that we monetize through differentiated programmable logic semiconductor products, system solutions, design services, and licenses. Lattice is the low power programmable leader. We solve customer problems across the network, from the Edge to the Cloud, in the growing communications, computing, industrial, automotive, and consumer markets. Our technology, long-standing relationships, and commitment to world-class support enable our customers to create a smart, secure, and connected world.

Lattice has focused its strategy on delivering programmable logic products and related solutions based on low power, small size, and ease of use. We also serve our customers with IP licensing and various other services. Our product development activities include new proprietary products, advanced packaging, existing product enhancements, software development tools, soft IP, and system solutions for high-growth applications such as Edge Artificial Intelligence, 5G infrastructure, platform security, and factory automation.

Critical Accounting Policies and Use of Estimates

Critical accounting policies are those that are both most important to the portrayal of a company's financial condition and results, and that require management's most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management believes that there have been no significant changes to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2019 10-K.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and judgments affecting the amounts reported in our consolidated condensed financial statements and the accompanying notes. The actual results that we experience may differ materially from our estimates.

Impact of COVID-19 on our Business

The COVID-19 pandemic has caused, and is expected to continue to cause, the global slowdown of economic activity (including the decrease in demand for goods and services), and significant volatility in and disruption to financial markets. Because the severity, magnitude and duration of the COVID-19 pandemic and its economic consequences are uncertain, rapidly changing and difficult to predict, the pandemic’s impact on our operations and financial performance, as well as its impact on our ability to successfully execute our business strategy and initiatives, remains uncertain. We took action quickly during the quarter to safeguard the health and well-being of our employees and our business. We implemented social distancing policies at our locations around the world including working from home and eliminating virtually all travel. Furthermore, we assessed our liquidity in light of the rapidly changing environment and preemptively drew down $50 million on our revolving credit facility to further solidify our cash position, and we have additional resources available under our Credit Agreement, if needed. As COVID-19 has spread to other jurisdictions and been declared a global pandemic, the full extent of this outbreak, the related governmental, business and travel restrictions in order to contain this virus are continuing to evolve globally.

We anticipate that these actions and the global health crisis caused by COVID-19 will negatively impact business activity across the globe. We expect our demand to be impacted in Q2 and potentially beyond Q2 given the global reach and economic impact of the virus. For example, governmental actions or policies or other initiatives to contain the virus, could lead to reductions in our end customers’ demand under which we would expect to lose revenue. We have also recently seen some disruptions in our supply chain due to governmental restrictions. If our suppliers experience similar impacts, we may have difficulty sourcing materials necessary to fulfill customer production requirements and transporting completed products to our end customers.

We will continue to actively monitor the situation and may take further actions altering our business operations that we determine are in the best interests of our employees, customers, partners, suppliers, and stakeholders, or as required by federal, state, or local authorities. It is not clear what the potential effects of any such alterations or modifications may have on our business, including the effects on our customers, employees, and prospects, or on our financial results for the remainder of fiscal 2020 or future periods.

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Results of Operations

Key elements of our Consolidated Statements of Operations, including as a percentage of revenue, are presented in the following table:

(In thousands)

Revenue by End Market

We sell our products globally in three primary groups of end markets: Communications and Computing, Industrial and Automotive, and Consumer. We also provide Intellectual Property licensing and services to these end markets.

We anticipate future revenue growth due to multiple market segment drivers, including:

• Communications and computing: 5G infrastructure deployments, cloud and enterprise servers, and client computing platforms,
• Industrial and automotive: industrial Internet of Things ("IoT"), factory automation, and automotive electronics,
• Consumer: smart home and prosumer.

We also generate revenue from the licensing of our Intellectual Property ("IP"), the collection of certain royalties, patent sales, the revenue related to our participation in consortia and standard-setting activities, and services. While these activities may be associated with multiple markets, Licensing and services revenue is reported as a separate end market as it has characteristics that differ from other categories, most notably a higher gross margin.

The end market data below is derived from data provided to us by our distributors and end customers. With a diverse base of customers who may manufacture end products spanning multiple end markets, the assignment of revenue to a specific end market requires the use of judgment. We also recognize certain revenue for which end customers and end markets are not yet known. We assign this revenue first to a specific end market using historical and anticipated usage of the specific products, if possible, and allocate the remainder to the end markets based on either historical usage for each product family or industry application data for certain product types.

The following are examples of end market applications for the periods presented:

The composition of our revenue by end market is presented in the following table:

(In thousands)

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Revenue from the Industrial and Automotive end market increased by 14% for the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019 due primarily to increased demand for our products used in a broad range of industrial applications including factory automation and robotics.

Revenue from the Communications and Computing end market increased by 8% for the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019 due to strength in the Computing end market due to the continued adoption of our products used in servers and client computing platforms.

Revenue from the Consumer end market decreased by 32% for the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019 due primarily to the expected shift of revenue towards our other market segments coupled with overall broad market macroeconomic weakness.

Revenue from the Licensing and Services end market is subject to variability between periods. Revenue from the Licensing and services end market decreased by 37% for the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019 primarily due to variability in HDMI royalty revenue and reduced patent and asset sales recognized in the first quarter of fiscal 2020.

Revenue by Geography

We assign revenue to geographies based on ship-to location of the end customer, where available, and based upon the location of the distributor to which the product was shipped otherwise.

The composition of our revenue by geography is presented in the following table:

(In thousands)

Revenue from End Customers

In the periods covered by this report, no end customer accounted for more than 10% of total revenue, and we expect to continue to sell our products to a broad base of end customers.

Revenue from Distributors

Distributors have historically accounted for a significant portion of our total revenue. Revenue attributable to our primary distributors is presented in the following table:

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Gross Margin

The composition of our Gross margin, including as a percentage of revenue, is presented in the following table:

(In thousands)

Gross margin, as a percentage of revenue, increased 30 basis points in the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019. Improved margins were driven by product cost reductions and benefits derived from pricing optimization actions, offset somewhat by product mix.

Because of its higher margin, the licensing and services portion of our overall revenue can have a disproportionate impact on Gross margin depending on the relative mix between product revenue and licensing and services revenue.

Operating Expenses

Research and Development Expense

The composition of our Research and development expense, including as a percentage of revenue, is presented in the following table:

(In thousands)

Research and development expense includes costs for compensation and benefits, stock compensation, engineering wafers, depreciation, licenses, and outside engineering services. These expenditures are for the design of new products, IP cores, processes, packaging, and software solutions. The increase in Research and development expense for the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019 was due primarily to increased headcount to support the expansion of our programmable logic product portfolio and acceleration of our product cadence. We believe that a continued commitment to Research and development is essential to maintaining product leadership and providing innovative new product offerings and, therefore, we expect to continue to make significant future investments in Research and development, particularly with expanded investment in the development of software solutions.

Selling, General, and Administrative Expense

The composition of our Selling, general, and administrative expense, including as a percentage of revenue, is presented in the following table:

(In thousands)

Selling, general, and administrative expense includes costs for compensation and benefits related to selling, general, and administrative employees, commissions, depreciation, professional and outside services, trade show, and travel expenses. The increase in Selling, general, and administrative expense for the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019 was due primarily to increased expenses for stock compensation and salaries, partially offset by reduced commissions resulting from our restructuring of the global sales organization in fiscal 2019.

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Amortization of Acquired Intangible Assets

The composition of our Amortization of acquired intangible assets, including as a percentage of revenue, is presented in the following table:

(In thousands)

The decrease in Amortization of acquired intangible assets for the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019 is due to the end of the amortization period for the majority of our acquired intangible assets during the first quarter of fiscal 2020.

Restructuring Charges

The composition of our Restructuring charges, including as a percentage of revenue, is presented in the following table:

(In thousands)

Restructuring charges are comprised of expenses resulting from reductions in our worldwide workforce, consolidation of our facilities, removal of fixed assets from service, and cancellation of software contracts and engineering tools. Details of our restructuring plans and expenses incurred under them are more fully discussed in "Note 6 - Restructuring" to our Consolidated Financial Statements in Part I, Item 1 of this report.

The decrease in restructuring expense in the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019 was driven by lower charges in the current year period, primarily for severance, compared to higher charges in the prior year period resulting from facility closure.

Interest Expense

The composition of our Interest expense, including as a percentage of revenue, is presented in the following table:

(In thousands)

Interest expense is primarily related to our long-term debt, which is further discussed under the Credit Arrangements heading in the Liquidity and Capital Resources section, below. This interest expense is comprised of contractual interest and amortization of original issue discount and debt issuance costs based on the effective interest method.

The decrease in Interest expense for the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019 was largely driven by the significant reduction in the effective interest rate on our long-term debt under the terms of the new Credit Agreement, coupled with the additional principal payments made in the current and previous periods. With the draw from our revolving loan facility during the first quarter of fiscal 2020, Interest expense will increase for the period that those funds remain outstanding.

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Other (Expense) Income, net

The composition of our Other (expense) income, net, including as a percentage of revenue, is presented in the following table:

(In thousands)

For the first quarter of fiscal 2020 compared to the first quarter of fiscal 2019, Other (expense) income, net changed primarily due to reductions in miscellaneous income and the non-recurrence of realized gains on investments with the liquidation of all of our short-term marketable securities in the first quarter of fiscal 2019.

Income Taxes

The composition of our Income tax expense is presented in the following table:

(In thousands)

Our Income tax expense is composed primarily of foreign income and withholding taxes, partially offset by benefits resulting from the release of uncertain tax positions ("UTP") due to statute of limitation expirations that occurred in the respective periods. The increase in expense in the first quarter of fiscal 2020 as compared to the first quarter of fiscal 2019 results primarily from an increase in foreign withholding taxes and UTP expense partially offset by release of uncertain tax positions due to statute of limitations expirations.

We are not currently paying U.S. federal income taxes and do not expect to pay such taxes until we fully utilize our tax net operating loss and credit carryforwards. We expect to pay a nominal amount of state income tax. We are paying foreign income taxes, which are primarily related to withholding taxes on income from foreign royalties, foreign sales, and the cost of operating offshore research and development, marketing, and sales subsidiaries. It is reasonably possible that during the next twelve months, we will establish a sustained level of profitability in the U.S. As a result, we may reverse a significant portion of the valuation allowance recorded against our U.S. deferred tax assets. The reversal would result in an income tax benefit for the quarterly and annual fiscal period in which we release the valuation allowance. We accrue interest and penalties related to uncertain tax positions in income tax expense on our Consolidated Statements of Operations. The inherent uncertainties related to the geographical distribution and relative level of profitability among various high and low tax jurisdictions make it difficult to estimate the impact of the global tax structure on our future effective tax rate.

Liquidity and Capital Resources

The following sections discuss material changes in our financial condition from the end of fiscal 2019, including the effects of changes in our Consolidated Balance Sheets, and the effects of our credit arrangements and contractual obligations on our liquidity and capital resources.

We have historically financed our operating and capital resource requirements through cash flows from operations, and from the issuance of long-term debt to fund acquisitions. Cash provided by or used in operating activities will fluctuate from period to period due to fluctuations in operating results, the timing and collection of accounts receivable, and required inventory levels, among other things.

We believe that our financial resources will be sufficient to meet our working capital needs through at least the next 12 months. As of March 28, 2020, we did not have significant long-term commitments for capital expenditures. In the future, we may continue to consider acquisition opportunities to further extend our product or technology portfolios and further expand our product offerings. In connection with funding capital expenditures, acquisitions, securing additional wafer supply, increasing our working capital, or other operations, we may seek to obtain equity or additional debt financing, or advance purchase payments or similar arrangements with wafer manufacturers. We may also seek to obtain equity or additional debt financing if we experience downturns or cyclical fluctuations in our business that are more severe or longer than we anticipated when determining our current working capital needs. On May 17, 2019, we entered into our Current Credit Agreement that is more fully discussed under the "Credit Arrangements" heading, below.

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Cash and cash equivalents

(In thousands)

As of March 28, 2020, we had Cash and cash equivalents of $176.6 million, of which approximately $83.5 million was held by our foreign subsidiaries. We manage our global cash requirements considering, among other things, (i) available funds among our subsidiaries through which we conduct business, (ii) the geographic location of our liquidity needs, and (iii) the cost to access international cash balances. The repatriation of non-US earnings may require us to withhold and pay foreign income tax on dividends. This should not result in our recording significant additional tax expense as we have accrued expense based on current withholding rates. As of March 28, 2020, we could access all cash held by our foreign subsidiaries without incurring significant additional expense.

The net increase in Cash and cash equivalents of $58.5 million between December 28, 2019 and March 28, 2020 was primarily driven by cash flows from the following activities:

Operating activities — Cash provided by operating activities results from net income adjusted for certain non-cash items and changes in assets and liabilities. Cash provided by operating activities for the first three months of fiscal 2020 was $21.1 million, a decrease of $0.7 million from the $21.8 million of cash provided by operating activities for the first three months of fiscal 2019. This decrease was driven by $4.6 million of changes in working capital, primarily due to the increase in accounts receivable partially offset by the reduction of inventory. This was substantially offset by an increase of $3.9 million provided by improved operating performance. We are using cash provided by operating activities to invest in our operations.

Investing activities — Investing cash flows consist primarily of transactions related to capital expenditures and payments for software licenses, and, in the prior year, short-term marketable securities. The $6.6 million of cash used by investing activities in the first three months of fiscal 2020 was an $11.4 million change from the $4.8 million provided by investing activities in the first three months of fiscal 2019 primarily due to the non-recurrence of the $9.7 million provided by our liquidation of all short-term investments in the first quarter of fiscal 2019. The total $6.6 million of cash used in the first three months of fiscal 2020 for capital expenditures and payments for software licenses was $1.8 million greater than the $4.8 million used in the first three months of fiscal 2019 due primarily to increased investments in test equipment and software enhancements.

Financing activities — Financing cash flows consist primarily of activity on our long-term debt, proceeds from the exercise of options to acquire common stock, and tax payments related to the net share settlement of restricted stock units. During the first three months of fiscal 2020, we drew $50.0 million on our revolving loan facility and paid a required quarterly installment of $4.4 million on our long-term debt. Payments for tax withholdings on vesting of RSUs partially offset by employee exercises of stock options used net cash flows of $1.5 million in the first three months of fiscal 2020, which is a change of approximately $13.1 million from the $11.6 million provided in the first three months of fiscal 2019.

Accounts receivable, net

(In thousands)

Accounts receivable, net as of March 28, 2020 increased by approximately $3.7 million, or 6%, compared to December 28, 2019. This increase resulted primarily from the timing of shipments to certain customers in March 2020 compared to December 2019.

Inventories

(In thousands)

Inventories as of March 28, 2020 decreased $6.0 million, or approximately 11%, compared to December 28, 2019 primarily due to our improved management of inventory levels, as well as the ramp down of mature and aging products.

The Days of inventory on hand ratio compares the inventory balance at the end of a quarter to the cost of sales in that quarter. Our Days of inventory on hand decreased to 112 days at March 28, 2020 from 123 days at December 28, 2019. This decrease resulted from improved inventory management.

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Credit Arrangements

On May 17, 2019, we entered into our Credit Agreement with Wells Fargo Bank, National Association, as administrative agent, and other lenders. The details of this new arrangement are more fully described in "Note 5 - Long-Term Debt" in the accompanying Notes to Consolidated Financial Statements.

As of March 28, 2020, we had no significant long-term purchase commitments for capital expenditures or existing used or unused credit arrangements beyond the secured revolving loan facility described above.

Share Repurchase Program

On March 24, 2020, we announced that our Board of Directors had approved a stock repurchase program pursuant to which up to $40.0 million of outstanding common stock may be repurchased from time to time. The duration of the repurchase program is twelve months. No shares have been repurchased under this program during the quarter ended March 28, 2020. We expect that all future repurchases will be open market transactions funded from available working capital. In the current environment, we expect to be more conservative on potential buyback activity as we focus on preserving capital and continue to invest in our business.

Contractual Cash Obligations

There have been no material changes to our contractual cash obligations outside of the ordinary course of business in the first three months of fiscal 2020, as summarized in Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's Annual Report on Form 10-K for the year ended December 28, 2019.

Off-Balance Sheet Arrangements

As of March 28, 2020, we did not have any off-balance sheet arrangements of the type described by Item 303(a)(4) of SEC Regulation S-K.

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Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates and interest rates. We assess these risks on a regular basis and have established policies that are designed to protect against the adverse effects of these and other potential exposures.

Foreign Currency Exchange Rate Risk

There have been no material changes to the foreign currency exchange rate risk previously disclosed in Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk," of our Annual Report on Form 10-K for the fiscal year ended December 28, 2019.

Interest Rate Risk

We are exposed to interest rate risk related to our indebtedness. At March 28, 2020, we had $193.8 million outstanding under our Credit Agreement. A hypothetical increase in the one-month LIBOR by 1% (100 basis points) would increase our future interest expense by approximately $0.5 million per quarter.

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

In connection with the filing of this Form 10-Q, our management, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls were effective as of the end of the period covered by this report.

Changes in Internal Control over Financial Reporting

There were no changes in our internal controls over financial reporting (as defined in Rules 13a-15(f) under the Exchange Act) that occurred during the first quarter of fiscal 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

We do not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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The risks described in Part I, Item 1A, “Risk Factors,” in our Annual Report on Form 10-K for the fiscal year ended December 28, 2019 ("2019 10-K") could materially and adversely affect our business, financial condition, and results of operations, and the trading price of our common stock could decline. The additional risk factor described below supplements the risk factors described in our 2019 10-K based on information currently known to us and recent developments since the filing date of that report. The matters discussed below should be read in conjunction with the risk factors set forth in the 2019 10-K.

The risks described in this report and in our 2019 10-K are not the only risks facing our company. Additional risks and uncertainties not presently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition, and operating results, particularly in light of the rapidly changing nature of the COVID-19 pandemic, containment measures, and the related impacts to economic and operating conditions. These factors, together with all of the other information in this Quarterly Report on Form 10-Q, including our unaudited condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q, should be carefully considered before making an investment decision relating to our common stock.

The COVID-19 pandemic could adversely affect our business in a material way.

COVID-19 has spread internationally and been declared a pandemic, affecting the populations of the United States as well as many countries around the world. The outbreak has resulted in significant governmental measures being implemented to control the spread of COVID-19, including, among others, restrictions on travel, manufacturing and the movement of employees in many regions of the world, and the imposition of remote or work-from-home mandates in many of our offices, including in the United States, the Philippines and, for a time, China. The majority of our products are manufactured, assembled, and tested by third parties in Asia. In addition, we rely on third party vendors for certain logistics and shipping operations throughout the world, including in Malaysia, Singapore, South Korea, Japan, and Taiwan. We also have other operations in China, the Philippines, and the United States. If the remote or work-from-home conditions in any of our offices continues for an extended period of time, we may experience delays in product development, a decreased ability to support our customers, reduced design win activity, and overall lack of productivity. Pandemics and epidemics such as the current COVID-19 outbreak or other widespread public health problems could negatively impact our business. If, for example, COVID-19 continues to progress in ways that significantly disrupt the manufacture, shipment and buying patterns of our products or the products of our customers, this may materially negatively impact our operating results for the current period and subsequent periods, including revenue, gross margins, operating margins, cash flows and other operating results and our overall business. Our customers may also experience closures of their manufacturing facilities or inability to obtain other components, either of which could negatively impact demand for our solutions. COVID-19 has negatively impacted the overall economy and, as a result of the foregoing, will likely negatively impact our operating results for the current fiscal year and may do so in a material way. In particular, COVID-19 may increase or change the severity of our other risks reported in our Annual Report on Form 10-K for the fiscal year ended December 28, 2019, including that:

• Our subcontractor suppliers who manufacture silicon wafers, packaging and testing to deliver our semiconductor products may be unable to meet delivery expectations to meet customer demand;
• Our distributors and customers may experience adverse performance and any reduction in the use of our products by our end customers could harm our sales and significantly decrease our revenue;
• The semiconductor industry could experience a cyclical downturn, which could cause a meaningful reduction in demand for our products and adversely affect our operating results;
• Countries may adopt tariffs and trade sanctions or similar actions;
• We may be delayed in our development and introduction of new products that achieve customer and market acceptance;
• Our operations may be disrupted if employees are unavailable due to illness, risk of illness, travel restrictions, or other factors that may limit our access to key personnel or critical skills;
• Shortages in or increased costs for silicon wafers, packaging materials, testing and shipping could adversely impact our gross margin and lead to reduced revenue;
• We may experience difficulty in maintaining the uninterrupted operation of our information technology systems, or be exposed to increased risk of a cyber-security incident or fraud, due to an increased reliance on remote work;
• We may incur impairments of goodwill and otherwise as required under U.S. GAAP;
• Our outstanding indebtedness could reduce our strategic flexibility and liquidity and may have other adverse effects on our results of operations.

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The impact of COVID-19 may exacerbate the risk factors listed above and in our Annual Report on Form 10-K, or cause them to change in importance. Developments related to the pandemic have been rapidly changing, and additional impacts and risks may arise that we are not aware of or able to appropriately respond to currently. As of the filing of this Quarterly Report, the extent to which the coronavirus will affect our business is highly uncertain and dependent on future developments that are inherently unpredictable, which makes forecasting demand and providing guidance especially difficult. Accordingly, our expectations are subject to change without warning and investors are cautioned not to place undue reliance on them.