Universal Display Corp \pa\: Form 10-Q for the period ended Mar 31, 2020

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 above.

CAUTIONARY STATEMENT

CONCERNING FORWARD-LOOKING STATEMENTS

This discussion and analysis contains some “forward-looking statements.” Forward-looking statements concern possible or assumed future results of operations, including descriptions of our business strategies and customer relationships. These statements often include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “seek,” “will,” “may” or similar expressions. These statements are based on assumptions that we have made in light of our experience in the industry, as well as our perceptions of historical trends, current conditions, expected future developments and other factors that we believe are appropriate in these circumstances.

As you read and consider this discussion and analysis, you should not place undue reliance on any forward-looking statements. You should understand that these statements involve substantial risk and uncertainty and are not guarantees of future performance or results. They depend on many factors that are discussed further in the section entitled (Risk Factors) in our Annual Report on Form 10-K for the year ended December 31, 2019, as supplemented by disclosures in Item 1A of Part II below. Changes or developments in any of these areas could affect our financial results or results of operations and could cause actual results to differ materially from those contemplated in the forward-looking statements.

All forward-looking statements speak only as of the date of this report or the documents incorporated by reference, as the case may be. We do not undertake any duty to update any of these forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.

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, 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:

• sales of OLED materials for evaluation, development and commercial manufacturing;
• intellectual property and technology licensing;
• technology development and support, including third-party collaboration efforts and providing support to third parties for commercialization of their OLED products; and
• 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 control 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.

In 2018, we entered into a commercial license agreement with Samsung Display Co., Ltd. (SDC). This agreement, which covers the manufacture and sale of specified OLED display materials, was effective as of January 1, 2018 and lasts through the end of 2022 with an additional two-year extension option. Under this agreement, we are being paid a license fee, payable in quarterly installments 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. Under the material purchase agreement, SDC agrees to purchase from us a minimum amount of 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 agreements have a term that is set to expire by the end of 2022. 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 agreements include customary provisions relating to warranties, indemnities, confidentiality, assignability and business terms. 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 to be generated under the patent license agreement. We generate revenue under these agreements that are predominantly tied to LG Display’s sales of OLED 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.

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 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 Visionox 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 Visionox’s sales of licensed products. Additionally, we supply phosphorescent OLED materials to Visionox for use in its licensed products.

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) with operations in New Castle, Delaware. Adesis is a contract research organization (CRO) that provides support services to the OLED, pharma, biotech, catalysis and other industries. As of March 31, 2020, Adesis employed a team of 97 research scientists, chemists, engineers and laboratory technicians. Prior to our acquisition of Adesis in 2016, 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.

We also generate technology development and support revenue earned from development and technology evaluation agreements and commercialization assistance fees, along with, to a minimal extent, government contracts. Relating to our government contracts, we may receive reimbursements by government entities for all or a portion of the research and development costs we incur. Revenues are recognized as services are performed, proportionally as research and development costs are incurred, or as defined milestones are achieved.

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

• the timing, cost and volume of sales of our OLED materials;
• the timing of our receipt of license fees and royalties, as well as fees for future technology development and evaluation;
• the timing and magnitude of expenditures we may incur in connection with our ongoing research and development and patent-related activities; and
• the timing and financial consequences of our formation of new business relationships and alliances.

Further, we are monitoring the impact of the novel coronavirus 2019 (COVID-19) on our business. Our global operations, and the global nature of our customer base, expose us to risks associated with public health crises, such as pandemics and epidemics. While we believe the ongoing COVID-19 pandemic had a limited impact on our operations and financial results for the three months ended March 31, 2020, we expect the pandemic, as it evolves, to have an adverse impact on our results of operations, due in large part to the potential disruption of the global economy and its 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 as required by our customers. However, this sustainability is uncertain and is dependent upon the rapidly evolving situations being encountered by our logistics and supply chain partners. In an effort to protect the health and safety of our employees, we have taken proactive measures to adopt social distancing policies at all of our locations, including working from home, reducing the number of people in our sites at any one time, and suspending employee travel.

While the ultimate health and economic impact of the COVID-19 pandemic is highly uncertain, we expect that our business operations and results of operations, including our revenues, net income and cash flows, will be adversely impacted for at least the balance of 2020, including as a result of:

• temporary closure of electronics and other retail stores through which our customers sell the products for which they use our technology and materials;
• consumer confidence and consumer spending habits, including spending for the products that our customers sell and negative trends in consumer purchasing patterns due to consumers’ disposable income, credit availability and debt levels;
• possible disruption to the supply chain caused by distribution and other logistical issues, which may impact suppliers of our raw materials;
• decreased productivity due to travel ban, work-from-home policies or shelter-in-place orders;
• a slowdown in the U.S. economy, and uncertain global economic outlook or a credit crisis.

We are focused on navigating these recent challenges presented by COVID-19 through preserving our liquidity and managing our cash flow. We continue to actively monitor the COVID-19 situation and may take further actions altering our business operations that we determine are in the best interests of our employees, customers, partners, suppliers, and stakeholders, or as required by federal, state, or local authorities. It is not clear what the potential effects any such alterations or modifications may have on our business, including the effects on our customers, employees, and on our financial results for the remainder of the 2020 fiscal year.

RESULTS OF OPERATIONS

Comparison of the Three Months Ended March 31, 2020 and 2019

Revenue

During the three months ended March 31, 2020, we recognized revenue of $112.3 million, an increase of $24.5 million from $87.8 million in the three months ended March 31, 2019. We believe the increase in revenue was mainly due to the impact from customer inventory management efforts to minimize the effects of potentially heightened trade tensions between the governments of China and the United States and estimated advanced material purchases due to the potential for future supply disruptions resulting from the COVID-19 pandemic.

Revenue derived from OLED sales comprised 98% of total revenue for the three months ended March 31, 2020 as compared to 97% for the three months ended March 31, 2019. The remaining portion of our revenue was derived from contract research services. 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 three months ended March 31, 2020 increased by $6.6 million as compared to the three months ended March 31, 2019, primarily due to an increase in the level of material sales. Included in the cost of sales for the three months ended March 31, 2020 and 2019, was an increase in inventory reserve of $611,000 and $224,000, respectively, due to excess inventory levels in certain products. As a result of the increase in material sales, gross margin for the three months ended March 31, 2020, increased by $17.9 million as compared to the three months ended March 31, 2019, with gross margin as a percentage of revenue decreasing to 80% from 82%.

Research and development

Research and development expenses increased to $19.5 million for the three months ended March 31, 2020, as compared to $15.8 million for the three months ended March 31, 2019. The increase in research and development expenses was primarily due to higher employee-related compensation expenses and operating costs, including increased contract research activity.

Selling, general and administrative

Selling, general and administrative expenses increased to $15.4 million for the three months ended March 31, 2020, as compared to $12.0 million for the three months ended March 31, 2019. The increase in selling, general and administrative expenses was primarily due to higher employee-related compensation expenses.

Amortization of acquired technology and other intangible assets

Amortization of acquired technology and other intangible assets was $5.5 million for both of the three-month periods ended March 31, 2020 and 2019.

Patent costs

Patent costs decreased to $1.6 million for the three months ended March 31, 2020, as compared to $1.8 million for the three months ended March 31, 2019. The results in the current year quarter reflected lower outside counsel fees offset by higher talent related maintenance costs and higher internal patent prosecution related costs.

Royalty and license expense

Royalty and license expense increased to $3.3 million for the three months ended March 31, 2020, as compared to $2.5 million for the three months ended March 31, 2019. The increase was due to increased royalties incurred under our amended license agreement with Princeton, USC and Michigan, resulting from an increase in qualifying material sales. See Note 9 in Notes to the Consolidated Financial Statements for further discussion.

Interest and other income, net

Interest income, net was $2.1 million for the three months ended March 31, 2020, as compared to $2.8 million for the three months ended March 31, 2019. The decrease in interest income, net was primarily due to a decrease in bond yields on available-for-sale investments held in the current quarter over bond yields on available-for-sale investments held in the comparable period in 2019. Other income, net primarily consisted of net exchange gains and losses on foreign currency transactions and rental income. We recorded other income, net of $202,000 for the three months ended March 31, 2020 as compared to $282,000 for the three months ended March 31, 2019.

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 18.6% and 16.0% for the three months ended March 31, 2020 and 2019, respectively, and we recorded income tax expense of $8.7 million and $6.0 million, respectively, for those periods. The recorded amounts include deductions for employee share awards in excess of compensation costs (“windfalls”) under Accounting Standards Update (ASU) No. 2016-09. For the three months ended March 31, 2020, without the $450,000 benefit of ASU No. 2016-09, the effective income tax rate and income tax expense would have been 19.5% and $9.2 million, respectively, and for the three months ended March 31, 2019, without the $1.5 million benefit of ASU No. 2016-09, the effective income tax rate and income tax expense would have been 20.0% and $7.5 million, respectively.

Liquidity and Capital Resources

Our principal sources of liquidity are our cash and cash equivalents and our short-term investments. As of March 31, 2020, we had cash and cash equivalents of $222.7 million and short-term investments of $417.1 million, for a total of $639.8 million. This compares to cash and cash equivalents of $131.6 million and short-term investments of $514.5, for a total of $646.1 million, as of December 31, 2019.

Cash provided by operating activities for the three months ended March 31, 2020 was $5.7 million resulting from $38.2 million of net income, partially offset by a $24.5 million reduction due to non-cash items including amortization of deferred revenue, amortization of intangibles and stock-based compensation, and a $8.0 million reduction due to changes in our operating assets and liabilities. Changes in our operating assets and liabilities related to a decrease in accounts payable and accrued expenses of $29.3 million, an increase in accounts receivable of $22.2 million and an increase in inventory of $10.7 million, partially offset by an increase in deferred revenue of $43.7 million, an increase in other liabilities of $6.1 million and a decrease in other assets of $4.4 million.

Cash provided by operating activities for the three months ended March 31, 2019 was $34.1 million resulting from $31.5 million of net income and $17.8 million due to changes in our operating assets and liabilities, partially offset by a $15.2 million reduction due to non-cash items including amortization of deferred revenue, depreciation and amortization of intangibles. Changes in our operating assets and liabilities related to an increase in deferred revenue of $33.1 million and a reduction of inventory of $1.7 million, partially offset by an increase in accounts receivable of $9.0 million, a reduction of accounts payable, accrued expenses and other liabilities of $5.2 million and an increase in other assets of $2.8 million.

Cash provided by investing activities was $97.0 million the three months ended March 31, 2020, as compared to cash used in investing activities of $9.1 million for the three months ended March 31, 2019. The increase was due to the timing of maturities and purchases of investments resulting in net sales of $101.8 million for the three months ended March 31, 2020, as compared to $4.6 million for the three months ended March 31, 2019, partially offset by a decrease in purchases of intangibles and property, plant and equipment of $8.9 million for the three months ended March 31, 2020 compared to the three months ended March 31, 2019. The decrease in property, plant and equipment purchases during 2020 was primarily due to improvements to our Ewing facilities in New Jersey as part of our plan to expand operations during 2019.

Cash used in financing activities was $11.7 million for the three months ended March 31, 2020, as compared to $10.9 million for the three months ended March 31, 2019. The increase was due to an increase in the cash payment of dividends in the current year of $2.4 million, partially offset by a decrease in the payment of withholding taxes related to stock-based compensation to employees of $941,000, a decrease in the repurchase of common stock of $649,000 and an increase in proceeds from the issuance of common stock of $55,000.

Working capital was $675.5 million as of March 31, 2020, compared to $630.9 million as of December 31, 2019. The increase was primarily due to an increase in cash and cash equivalents, a decrease in accrued expenses, an increase in accounts receivable, and an increase in inventory, partially offset by a decrease in short-term investments.

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 12 months. However, the extent to which the COVID-19 pandemic and our precautionary measures in response thereto may impact our business 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, public and private sales of our equity and debt securities and the receipt of cash upon the exercise of outstanding stock options. 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.

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 Consolidated 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, inventories, and income taxes are our “critical accounting policies” as contemplated by the SEC.

Refer to our Annual Report on Form 10-K for the year ended December 31, 2019, for additional discussion of our critical accounting policies.

Contractual Obligations

Refer to our Annual Report on Form 10-K for the year ended December 31, 2019 for a discussion of our contractual obligations.

Off-Balance Sheet Arrangements

As of March 31, 2020, we had no off-balance sheet arrangements in the nature of guarantee contracts, retained or contingent interests in assets transferred to unconsolidated entities (or similar arrangements serving as credit, liquidity or market risk support to unconsolidated entities for any such assets), or obligations (including contingent obligations) arising out of variable interests in unconsolidated entities providing financing, liquidity, market risk or credit risk support to us, or that engage in leasing, hedging or research and development services with us.

We do not utilize financial instruments for trading purposes and hold no derivative financial instruments, other financial instruments or derivative commodity instruments that could expose us to significant market risk other than our investments disclosed in “Fair Value Measurements” in Note 4 to the Consolidated Financial Statements included herein. We generally invest in investment grade financial instruments to reduce our exposure related to investments. Our primary market risk exposure with regard to such financial instruments is to changes in interest rates, which would impact interest income earned on investments. However, based upon the conservative nature of our investment portfolio and current experience, we do not believe a decrease in investment yields would have a material negative effect on our interest income.

Substantially all our revenue is derived from outside of North America. All revenue is primarily denominated in U.S. dollars and therefore we bear no significant foreign exchange risk.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2020. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures, as of the end of the period covered by this report, are effective to provide reasonable assurance that the information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act of 1934, as amended, is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (ii) accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure. However, a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the quarter ended March 31, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

This section supplements and updates certain of the information found under Part I, Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2019 based on information currently known to us and recent developments since the filing of such Annual Report on Form 10-K. The matters discussed below should be read in conjunction with the risk factors set forth in such Annual Report on Form 10-K.

We expect the COVID-19 pandemic to have a material adverse effect on our operations and business.

The COVID-19 pandemic has negatively impacted the global economy, disrupted consumer spending and global supply chains, and created significant volatility and disruption of financial markets. We expect the COVID-19 pandemic to have an adverse impact on our business and financial performance. The extent of the impact of the COVID-19 pandemic on our business and financial performance, including our ability to execute our near-term and long-term business strategies and initiatives in the expected time frame, will depend on future developments, including the duration and severity of the pandemic, which are uncertain and cannot be predicted.

As a result of the COVID-19 pandemic, and in response to government mandates or recommendations, as well as decisions we have made to protect the health and safety of our employees and communities, we have taken proactive measures to adopt social distancing policies at all of our locations, including working from home, reducing the number of people in our sites at any one time, and suspending employee travel. In the future, we may face closure requirements and other operational restrictions with respect to some or all of our physical locations for prolonged periods of time due to, among other factors, evolving and increasingly stringent governmental restrictions including public health directives, quarantine policies or social distancing measures. In addition, many of our customers may reduce their operations, as demand for their products becomes negatively affected, which would adversely impact our revenues from these customers. As a result, we would expect our financial results to be materially adversely impacted.

In addition, consumer spending generally may also be negatively impacted by general macroeconomic conditions and consumer confidence, including the impact of any recession, resulting from the COVID-19 pandemic. This may negatively impact sales for our customers and may also have an impact on their development of new products.

As a result of the COVID-19 pandemic, we have implemented a work from home policy for many of our corporate employees. This policy may negatively impact productivity and cause other disruptions to our business, and have material and adverse effects on our business, financial condition and results of operations.

The extent of the impact of the COVID-19 pandemic on our business is highly uncertain and difficult to predict, as information is rapidly evolving with respect to the duration and severity of the pandemic. At this point, we cannot reasonably estimate the duration and severity of the COVID-19 pandemic, or its overall impact on our business, financial condition and results of operations.