Sanmina-SCI 10-Q 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended July 2, 2011
For the transition period from to .
Commission File Number 0-21272
(Exact name of registrant as specified in its charter)
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [x] No [ ]
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [x] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [x]
As of July 28, 2011, there were 80,657,540 shares outstanding of the issuer's common stock, $0.01 par value per share.
CONDENSED CONSOLIDATED BALANCE SHEETS
See accompanying notes.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Basis of Presentation
The accompanying condensed consolidated financial statements of Sanmina-SCI Corporation (the “Company”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) have been omitted pursuant to those rules or regulations. The interim condensed consolidated financial statements are unaudited, but reflect all normal recurring and non-recurring adjustments that are, in the opinion of management, necessary for a fair presentation. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended October 2, 2010, included in the Company's 2010 Annual Report on Form 10-K.
The preparation of financial statements requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.
Results of operations for the nine months ended July 2, 2011 are not necessarily indicative of the results that may be expected for the full fiscal year.
The Company operates on a 52 or 53 week year ending on the Saturday nearest September 30. Fiscal 2011 and 2010 are each 52-week years. All references to years relate to fiscal years unless otherwise noted.
Note 2. Inventories
Components of inventories were as follows:
Note 3. Fair Value
Fair Value Option for Long-term Debt
The Company has elected not to record its long-term debt instruments at fair value, but has measured them at fair value for disclosure purposes. As of July 2, 2011, the carrying amount and estimated fair value of the Company's long-term debt instruments were $1,157.4 million and $1,147.8 million, respectively. Fair value was estimated based on either the most recent traded price, a quoted price or other market sources (Level 2 inputs).
Assets/Liabilities Measured at Fair Value on a Recurring Basis
The Company's primary financial assets and financial liabilities are as follows:
Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures, defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. When determining fair value measurements for assets and liabilities required to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and also considers assumptions that market participants would use when pricing an asset or liability.
Inputs to valuation techniques used to measure fair value are prioritized into three broad levels (fair value hierarchy), as follows:
Level 1: Observable inputs that reflect quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2: Inputs that reflect quoted prices, other than quoted prices included in Level 1, that are observable for the assets or liabilities, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in less active markets; or inputs that are derived principally from or corroborated by observable market data by correlation.
Level 3: Unobservable inputs that are supported by little or no market activity and that are significant to the measurement of the fair value of assets or liabilities.
There were no transfers between levels in the fair value hierarchy during any period presented herein. The following table presents information as of July 2, 2011 with respect to assets and liabilities measured at fair value on a recurring basis:
(1) Liabilities, or credit balances, are presented as negative amounts.
The following table presents information as of October 2, 2010 with respect to assets and liabilities measured at fair value on a recurring basis:
(1) Liabilities, or credit balances, are presented as negative amounts.
The Company sponsors deferred compensation plans for eligible employees and non-employee members of its Board of Directors that allow participants to defer payment of part or all of their compensation. The Company's results of operations are not significantly affected by these plans since changes in the fair value of the assets substantially offset changes in the fair value of the liabilities. As such, assets and liabilities associated with these plans have not been included in the above tables. Assets and liabilities associated with these plans of approximately $12.0 million as of July 2, 2011 and $10.8 million as of October 2, 2010 are recorded as other non-current assets and other long-term liabilities in the condensed consolidated balance sheet.
The Company values derivatives using observable Level 2 market expectations at the measurement date and standard valuation techniques to convert future amounts to a single present value amount assuming that participants are motivated, but not compelled, to transact. The Company seeks high quality counterparties for all financing arrangements. For interest rate swaps, Level 2 inputs include short-term LIBOR rates, futures contracts on LIBOR between two and four years, longer term swap rates at commonly quoted intervals, and credit default swap rates for the Company and relevant counterparties. For currency contracts, Level 2 inputs include foreign currency spot and forward rates and interest rates at commonly quoted intervals. Mid-market pricing is used as a practical expedient for fair value measurements. ASC Topic 820 requires the fair value measurement of an asset or liability to reflect the nonperformance risk of the entity and the counterparty. Therefore, the counterparty's creditworthiness when in an asset position and the Company's creditworthiness when in a liability position have been considered in the fair value measurement of derivative instruments. The effect of nonperformance risk on the fair value of derivative instruments was not material as of July 2, 2011 and October 2, 2010.
Non-Financial Assets Measured at Fair Value on a Nonrecurring Basis
The Company's assets held-for-sale consist of land and buildings that are measured at fair value on a nonrecurring basis since these assets are subject to fair value adjustments only when the carrying amount of such assets exceeds the fair value of such assets or such assets have been previously impaired and the fair value exceeds the carrying amount by less than the amount of the impairment that has been recognized. Level 2 inputs consist of independent third party valuations based on market comparables. The carrying value of the Company's assets held-for-sale was $47.0 million as of July 2, 2011 and is included in prepaid expenses and other current assets in the condensed consolidated balance sheet.
Note 4. Derivative Financial Instruments
The Company is exposed to certain risks related to its ongoing business operations. The primary risks managed by using derivative instruments are interest rate risk and foreign exchange rate risk.
Interest Rate Risk
Interest rate swaps are entered into on occasion to manage interest rate risk associated with borrowings under the Company's long-term debt arrangements.
Cash Flow Hedges
The Company has $257.4 million of floating rate notes outstanding as of July 2, 2011 and has entered into interest rate swap agreements with two independent swap counterparties to hedge its interest rate exposure. The swap agreements, with an aggregate notional amount of $257 million and expiration dates of June 15, 2014, effectively convert the variable interest rate obligation to a fixed interest rate obligation and are accounted for as cash flow hedges under ASC Topic 815, Derivatives and Hedging. Under the terms of the swap agreements, the Company pays the independent swap counterparties a fixed rate and the swap counterparties pay the Company an interest rate equal to the three-month LIBOR. These swap agreements effectively fix the interest rate at 8.344% through maturity.
Fair Value Hedge
The Company has $500 million of fixed-rate senior notes outstanding as of July 2, 2011 and has entered into an interest rate swap to hedge its exposure to interest rates related to these notes. The swap agreement, with a notional amount of $500 million and an expiration date of May 15, 2019, was entered into contemporaneously with the 2019 Notes and effectively converts these notes from fixed-rate debt to variable-rate debt. Pursuant to the interest rate swap, the Company pays the swap counterparty a variable rate equal to the three-month LIBOR plus a spread and receives a fixed rate of 7.0% from the swap counterparty. In accordance with ASC 815, the interest rate swap is accounted for as a fair value hedge but is exempt from periodic assessment of hedge effectiveness. Therefore, the change in the fair value of the 2019 Notes resulting from changes in interest rates is assumed to be equal and opposite to the change in the fair value of the interest rate swap. As of July 2, 2011, the fair value of the interest rate swap, based on observable market data (Level 2), was $5.5 million and is included in other long-term liabilities on the Company's condensed consolidated balance sheet.
Foreign Exchange Rate Risk
Forward contracts on various foreign currencies are used to manage foreign currency risk associated with forecasted foreign currency transactions and certain monetary assets and liabilities denominated in foreign currencies. The Company's primary foreign currency cash flows are in certain Asian and European countries, Israel and Mexico.
The Company had the following outstanding foreign currency forward contracts that were entered into to hedge foreign currency exposures:
The Company enters into short-term foreign currency forward contracts to hedge currency exposures associated with certain monetary assets and liabilities denominated in foreign currencies. These contracts have maturities of up to two months and are not designated as accounting hedges under ASC 815. Accordingly, these contracts are marked-to-market at the end of each period with unrealized gains and losses recorded in other income (expense), net, in the condensed consolidated statements of income. For the three and nine months ended July 2, 2011, the Company recorded losses of $1.7 million and gains of $1.7 million, respectively, associated with these forward contracts. For the three and nine months ended July 3, 2010, the Company recorded gains of $14.0 million and $27.3 million, respectively, associated with these forward contracts. Gains and losses on forward contracts substantially offset gains and losses on the underlying hedged items for all periods presented herein.
The Company also utilizes foreign currency forward contracts to hedge certain operational (“cash flow”) exposures resulting from changes in foreign currency exchange rates. Such exposures generally result from 1) forecasted sales denominated in currencies other than those used to pay for materials and labor and 2) anticipated capital expenditures denominated in a currency other than the functional currency of the entity making the expenditures. These contracts are up to twelve months in duration and are accounted for as cash flow hedges under ASC 815.
For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (AOCI), an equity account, and
reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on derivative instruments representing hedge ineffectiveness are recognized in current earnings and were not material for any period presented herein. As of July 2, 2011, AOCI related to foreign currency forward contracts was not material and AOCI related to interest rate swaps was a loss of $31.5 million, of which $13.0 million is expected to be amortized to interest expense over the next 12 months.
The following table presents the effect of cash flow hedging relationships on the Company's condensed consolidated statement of income for the three and nine months ended July 2, 2011 and July 3, 2010, respectively:
Note 5. Debt
Long-term debt consisted of the following:
(1) Represents fair value hedge accounting balance related to interest rate swaps. See Note 4 for discussion of interest rate swap entered into during the current period.
On May 10, 2011, the Company issued $500.0 million aggregate principal amount of senior notes due 2019 (the "2019 Notes"). The 2019 Notes will mature on May 15, 2019 and bear interest at an annual rate of 7%, payable semi-annually in arrears. In connection with issuance of the 2019 Notes, the Company incurred debt issuance costs of $11.0 million. These costs are included in other non-current assets on the condensed consolidated balance sheet and are being amortized to interest expense over the term of the 2019 Notes using the effective interest method.
The 2019 Notes are senior unsecured obligations of the Company and are fully and unconditionally guaranteed on a senior, unsecured basis by substantially all of the Company's domestic subsidiaries. The Company may redeem all or any portion of the 2019 Notes at any time prior to May 15, 2014, at par plus accrued and unpaid interest plus a make-whole premium. The Company may redeem all or any portion of the 2019 Notes beginning on or after May 15, 2014, at redemption prices ranging from 100% - 105.25% of the principal amount of the 2019 Notes, plus accrued and unpaid interest. Following a change of control, as defined, each holder of the 2019 Notes shall have the right to require the Company to repurchase all or any portion of such holder's 2019 Notes at a purchase price equal to 101% of the principal amount, plus accrued and unpaid interest.
The indenture for the 2019 Notes includes certain covenants that place limitations on, among other things: debt, restricted payments, liens, asset sales, the Company's ability to create or permit restrictions on distributions from the Company's restricted subsidiaries, transactions with affiliates and consolidating or merging with other companies. The restrictive covenants are subject to a number of important exceptions and qualifications set forth in the indenture.
The indenture provides for customary events of default, including payment defaults, breaches of covenants, certain payment defaults at final maturity or acceleration of other indebtedness, failure to pay certain judgments, certain events of bankruptcy, insolvency and reorganization involving the Company or certain of its subsidiaries and certain instances in which a guarantee ceases to be in full force and effect. If any event of default occurs and is continuing, subject to certain exceptions, the trustee or the holders of at least 25% in aggregate principal amount of the then outstanding 2019 Notes may declare all the 2019 to be due and payable immediately, together with any accrued and unpaid interest. In the event of default resulting from certain events of bankruptcy, insolvency or reorganization involving the Company or certain of its subsidiaries, the 2019 Notes will be due and payable immediately without any declaration or other act on the part of the trustee or the holders of the 2019 Notes.
As discussed in Note 4, the Company entered into an interest rate swap to hedge its exposure to changes in the fair value of the 2019 Notes resulting from changes in interest rates. As of July 2, 2011, the fair value hedge accounting adjustment related to the 2019 Notes was $5.5 million and has been recorded as a reduction to long-term debt.
On May 10, 2011, in conjunction with a tender offer, the Company repurchased $279.3 million in aggregate principal amount of its 2013 Notes and $200.0 million in aggregate principal amount of its 2016 Notes. The aggregate purchase price for the notes was $488.7 million, consisting of $280.1 million for the 2013 Notes and $208.6 million for the 2016 Notes. The repurchases were funded in part by the issuance of the 2019 Notes discussed above. On June 10, 2011, the remaining outstanding 2013 Notes of $100.7 million in aggregate principal amount were repurchased at par.
In accordance with ASC Topic 470, Debt, the Company determined that all debt redeemed in connection with these transactions has been extinguished. Therefore, the Company recognized a loss on extinguishment of $16.1 million, consisting of redemption premiums of $9.4 million, third party costs of $1.3 million and a net write-off of unamortized debt costs of $5.4 million.
During 2010, one of the Company's subsidiaries in China entered into a $50 million unsecured working capital loan facility that contains certain negative covenants that, upon default, permit the bank to deny any further advances or extension of credit or to terminate the loan agreement. Additionally, one of the Company's subsidiaries in India entered into a $35 million working capital loan facility that contains no covenants.
Information with respect to short-term debt facilities is as follows:
Note 6. Commitments and Contingencies
Litigation and other contingencies. From time to time, the Company is a party to litigation, claims and other contingencies, including environmental and employee matters and examinations and investigations by governmental agencies, which arise in the ordinary course of business. The Company records a contingent liability when it is probable that a loss has been incurred and the amount of loss is reasonably estimable in accordance with ASC Topic 450, Contingencies or other applicable accounting standards. As of July 2, 2011 and October 2, 2010, the Company had reserves of $20.0 million and $22.3 million, respectively, for these matters, which the Company believes are adequate. Such reserves are included in accrued liabilities and other long-term liabilities on the condensed consolidated balance sheet.
Warranty Reserve. The following table presents information with respect to the warranty reserve, which is included in accrued liabilities in the condensed consolidated balance sheets:
Operating Leases. The Company leases certain of its land, facilities and equipment under non-cancelable operating leases expiring at various dates through 2040. The Company is responsible for utilities, maintenance, insurance and property taxes under these leases. Future minimum lease payments, net of sublease income, under operating leases are as follows:
Note 7. Restructuring
Costs associated with restructuring activities are accounted for in accordance with ASC Topic 420, Exit or Disposal Cost Obligations, or ASC Topic 712, Compensation - Nonretirement Postemployment Benefits, as applicable. Pursuant to ASC 712, restructuring costs related to employee severance are recorded when probable and estimable. For restructuring costs other than employee severance accounted under ASC 712, a liability is recognized in accordance with ASC 420 only when incurred.
During 2011, the Company changed its management structure and expects to incur employee severance and benefits costs of $2.2 million in cash and stock compensation expense. As of July 2, 2011, $0.8 million of cash remains payable and is expected to be paid by May 5, 2013.
Restructuring Plans — 2010 and prior
The Company initiated a restructuring plan in 2010 as a result of a business combination. Pursuant to this plan, the Company expects to incur costs up to $15.0 million to consolidate certain facilities and eliminate redundant employees, of which $9.8 million has been incurred to date. The amount of costs ultimately incurred will depend on the Company's ability to recover ongoing lease costs for vacant facilities by subleasing such facilities to third parties.
Due to completion of all actions under restructuring plans initiated prior to 2011 and immateriality of the remaining accrual balance related to such plans, these plans have been combined for disclosure purposes. The Company expects to incur restructuring costs in future periods associated primarily with vacant facilities until such time as those facilities have been sold or leased to third parties.
Below is a summary of restructuring costs associated with facility closures and other consolidation efforts that were implemented prior to 2011:
Costs incurred with respect to facilities consist primarily of 1) costs to maintain vacant facilities that are owned until such facilities can be sold and 2) the portion of the Company's lease payments that have not been recovered due to the absence of sublease income for vacant leased properties. The Company expects to pay the majority of accrued restructuring costs by September 2012.
Note 8. Earnings Per Share
Basic and diluted amounts per share are calculated by dividing net income or loss by the weighted average number of shares of common stock outstanding during the period, as follows:
The following table presents weighted-average dilutive securities that were excluded from the above calculation because their inclusion would have had an anti-dilutive effect:
Securities are anti-dilutive because 1) the exercise price is higher than the Company's stock price or 2) the application of the treasury stock method resulted in an anti-dilutive effect.
Note 9. Comprehensive Income
Other comprehensive income, net of tax as applicable, was as follows:
The net unrealized gain (loss) on derivative financial instruments is primarily attributable to changes in the fair market value of the Company's liability under its interest rate swaps that are accounted for as cash flow hedges. The fair market value
of these swaps changes primarily as a result of changes in interest rates.
Accumulated other comprehensive income, net of tax as applicable, consisted of the following:
Note 10. Business Segment, Geographic and Customer Information
ASC Topic 280, Segment Reporting, establishes standards for reporting information about operating segments, products and services, geographic areas of operations and major customers. Operating segments are defined as components of an enterprise for which separate financial information is available and is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company operates in one reportable segment, Electronic Manufacturing Services.
Information by geographic segment, determined based on the country in which a product is manufactured, was as follows:
Note 11. Stock-Based Compensation
Stock compensation expense by function and type of instrument was as follows:
As of July 2, 2011, an aggregate of 15.9 million shares were authorized for future issuance and 3.0 million shares of common stock were available for grant under the Company's stock plans, which include stock options and restricted stock awards and units.
Assumptions used to estimate the fair value of stock options granted were as follows:
Stock option activity was as follows:
The weighted-average grant date fair value of stock options granted during the three and nine months ended July 2, 2011 was $6.56 and $8.87, respectively. The weighted-average grant date fair value of stock options granted during the three and nine months ended July 3, 2010 was $11.06 and $6.53, respectively. The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value of in-the-money options that would have been received by the option holders had all option holders exercised their options at the Company's closing stock price on the date indicated.
As of July 2, 2011, unrecognized compensation expense related to stock options was $23.3 million, and is expected to be recognized over a weighted average period of 3.6 years.
Restricted Stock Units
The Company grants restricted stock units to executive officers, directors and certain management employees. These units vest over periods ranging from one to four years and are automatically exchanged for shares of common stock at the vesting date. Compensation expense associated with these units is recognized ratably over the vesting period.
As of July 2, 2011, unrecognized compensation expense related to restricted stock units was $15.5 million, and is expected to be recognized over a weighted average period of 2.4 years.
Activity with respect to the Company's non-vested restricted stock units was as follows:
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). These statements relate to our expectations for future events and time periods. All statements other than statements of historical fact are statements that could be deemed to be forward-looking statements, including any statements regarding trends in future revenues or results of operations, gross margin or operating margin, expenses, earnings or losses from operations, synergies or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning developments, performance or industry ranking; any statements regarding future economic conditions or performance; any statements regarding pending investigations, claims or disputes; any statements regarding the financial impact of customer bankruptcies; any statements regarding timing of closing of, future cash outlays for and benefits of acquisitions; any statements concerning the adequacy of our liquidity; any statements of expectation or belief; and any statements of assumptions underlying any of the foregoing. Generally, the words “anticipate,” “believe,” “plan,” “expect,” “future,” “intend,” “may,” “will,” “should,” “estimate,” “predict,” “potential,” “continue” and similar expressions identify forward-looking statements. Our forward-looking statements are based on current expectations, forecasts and assumptions and are subject to the risks and uncertainties contained in or incorporated from Part II, Item 1A of this report. As a result, actual results could vary materially from those suggested by the forward-looking statements. We undertake no obligation to publicly disclose any revisions to these forward-looking statements to reflect events or circumstances occurring subsequent to filing this report with the Securities and Exchange Commission.
We are a leading independent global provider of customized, integrated electronics manufacturing services, or EMS. Our revenue is generated from sales of our services primarily to original equipment manufacturers, or OEMs, in the communications; industrial, defense and medical; enterprise computing and storage; and multimedia markets.
Our strategy is to leverage our comprehensive service offering, vertically integrated manufacturing services, advanced technologies and global capabilities to further penetrate diverse end markets that we believe offer significant growth opportunities and have complex products that require higher value-added services. We believe this strategy differentiates us from our competitors and will drive more sustainable revenue growth and provide opportunities for us to ultimately achieve operating margins that exceed industry standards.
There are many challenges to successfully executing our strategy. For example, we compete with a number of companies in each of our key end markets. These include companies that are much larger than we are and smaller companies that focus on a particular niche. Although we believe we are well-positioned in each of our key end markets and are continuing to differentiate ourselves from our competitors, competition remains intense. Additionally, growing and leveraging our components manufacturing services to drive vertical integration and improve our operating margins continues to be challenging due to excess capacity and operational inefficiencies. Lastly, revenue from defense and aerospace and optical customers has decreased throughout 2011 and is expected to decrease further in our upcoming quarter. This creates pressure on our operating margins since our defense and aerospace business is typically one of our higher-margin businesses and a high level of infrastructure exists for optical products. We continue to address these challenges on both a short-term and long-term basis.
In late 2008, the business environment became challenging due to adverse global economic conditions. These conditions slowed global economic growth and resulted in recessions in many countries, including the U.S., Europe and certain countries in Asia. These conditions materially and adversely impacted our financial condition and results of operations for 2009. Global economic conditions improved throughout 2010, resulting in a substantial increase in our business volume. Our revenue increased on a quarterly basis throughout 2010. Although revenue was down sequentially in each of the first two quarters of 2011, revenue levels increased in the third quarter of 2011 and were up 5.9% for the nine months ended July 2, 2011 compared to the same period in 2010. Additionally, the third quarter of 2011 was our seventh consecutive profitable quarter, resulting primarily from increased business volume, continuing improvements in our components business, and the realization of benefits from our previous restructuring actions. Although our results of operations have not been impacted significantly by the recent natural disaster and related nuclear plant situation in Japan, there can be no assurance that future periods will not be significantly impacted. Our quarterly results of operations tend to fluctuate and may not be indicative of results to be expected for any future periods.
A relatively small number of customers have historically generated a significant portion of our net sales. Sales to our ten largest customers represented 50.2% and 49.2% of our net sales for the three and nine months ended July 2, 2011, respectively.
Sales to our ten largest customers represented 50.0% and 50.3% of our net sales for the three and nine months ended July 3, 2010, respectively. Additionally, one customer represented more than 10% of our net sales during the three months ended July 2, 2011, two customers represented more than 10% of our net sales during the three months ended July 3, 2010, and one customer represented more than 10% of our net sales for the nine months ended July 2, 2011 and July 3, 2010.
We perform a significant portion of our manufacturing in international locations. Sales derived from products manufactured in international operations during the three months ended July 2, 2011 and July 3, 2010 were 81.3% and 78.4%, respectively, of our total net sales. During the nine months ended July 2, 2011 and July 3, 2010, 81.7% and 78.5%, respectively, of our total net sales were derived from non-U.S. operations. This stems from a desire on the part of many of our customers to source production in lower cost locations such as Asia and Latin America. We expect this trend to continue.
Historically, we have had substantial recurring sales from existing customers. We typically enter into supply agreements with our major OEM customers. These agreements generally have terms ranging from three to five years and cover the manufacture of a range of products. These agreements generally do not obligate the customer to purchase minimum quantities of products. In some circumstances, our supply agreements with customers provide for cost reductions during the term of the agreement such that revenue and margin attributable to these contracts may reduce over their terms.
Critical Accounting Policies and Estimates
Management's discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. We review the accounting policies used in reporting our financial results on a regular basis. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate the process used to develop estimates for certain reserves and contingent liabilities, including those related to product returns, accounts receivable, inventories, investments, intangible assets, income taxes, warranty obligations, environmental matters, restructuring, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Our actual results may differ materially from these estimates.
For a complete description of our critical accounting policies and estimates, refer to our 2010 Annual Report on Form 10-K filed with the Securities and Exchange Commission on November 24, 2010.
Results of Operations
Key operating results
Net income includes restructuring and integration costs of $6.3 million and $6.2 million for the three months ended July 2, 2011 and July 3, 2010, respectively, and $15.9 million and $13.4 million for the nine months ended July 2, 2011 and July 3, 2010, respectively. Net income for the three and nine months ended July 2, 2011 includes a loss on extinguishment of debt of $16.1 million. Net income for the nine months ended July 3, 2010 includes other income of $35.6 million in connection with a legal settlement.
Net sales increased from $1.6 billion in the third quarter of 2010 to $1.7 billion in the third quarter of 2011, an increase of 3.0%. Net sales increased from $4.6 billion for the nine months ended July 3, 2010 to $4.9 billion for the nine months ended July 2, 2011, an increase of 5.9%. Sales by end market were as follows (dollars in thousands):
The increase in our communications end market is primarily attributable to increased demand from existing customers, both for established programs and new program wins for new technologies introduced by our customers. Despite a significant decrease in demand from defense customers, sales in our industrial defense and medical end market have been relatively flat due to stronger demand from industrial and medical customers. Sales to customers in our enterprise computing and storage end market decreased as a result of certain customer programs going end-of-life, the effect of which was not completely offset by new programs. Sales to customers in our multimedia market decreased primarily as a result of reduced demand from one program.
Gross margin increased from 7.6% for the three months ended July 3, 2010 to 7.9% for the three months ended July 2, 2011, and from 7.6% for the nine months ended July 3, 2010 to 7.7% for the nine months ended July 2, 2011. The increase for both the three and nine months ended July 2, 2011 was primarily the result of profit contribution from increased business volume and improved performance in components manufacturing services.
We expect gross margins to continue to fluctuate based on overall production and shipment volumes and changes in the mix of products demanded by our major customers. Fluctuations in our gross margins may also be caused by a number of other factors, some of which are outside of our control, including (a) greater competition in the EMS industry and pricing pressures from OEMs due to greater focus on cost reduction; (b) provisions for excess and obsolete inventory that we are not able to charge back to a customer or sales of inventories previously written down; (c) changes in operational efficiencies; (d) pricing pressure on electronic components resulting from economic conditions in the electronics industry; and (e) our ability to transition manufacturing and assembly operations to lower cost regions in an efficient manner.
Selling, general and administrative
Selling, general and administrative expenses increased from $65.4 million, or 4.0% of net sales, in the third quarter of 2010 to $67.0 million, or 4.0% of net sales, in the third quarter of 2011. For the nine month period, selling, general and administrative expenses decreased from $191.4 million, or 4.1% of net sales, in 2010 to $187.7 million, or 3.8% of net sales, in 2011. The increase for the three months ended July 2, 2011 was primarily due to increased personnel costs resulting from increased headcount, partially offset by lower bad debt and acquisition related costs. The decrease for the nine months ended July 2, 2011 was primarily due to reduced incentive compensation and bad debt expense, partially offset by higher personnel costs resulting from increased headcount.
Research and Development
Research and development expenses increased from $3.1 million, or 0.2% of net sales, in the third quarter of 2010 to $5.8 million, or 0.3% of net sales, in the third quarter of 2011. Research and development expenses increased from $9.4 million, or 0.2% of net sales, for the nine months ended July 3, 2010 to $14.9 million, or 0.3% of net sales, for the nine months ended July 2, 2011. The increase for both the three and nine month periods was primarily attributable to investments in new projects in multiple business units.
Costs associated with restructuring activities are accounted for in accordance with ASC Topic 420, Exit or Disposal Cost Obligations, or ASC Topic 712, Compensation - Nonretirement Postemployment Benefits, as applicable. Pursuant to ASC Topic 712, restructuring costs related to employee severance are recorded when probable and estimable. For restructuring costs other
than employee severance accounted for under ASC Topic 712, a liability is recognized in accordance with ASC Topic 420 only when incurred.
During 2011, we changed our management structure and expect to incur employee severance and benefits costs of $2.2 million in cash and stock compensation expense. As of July 2, 2011, $0.8 million of cash remains payable and is expected to be paid by May 5, 2013.
Restructuring Plans — 2010 and prior
We initiated a restructuring plan in 2010 as a result of a business combination. Pursuant to this plan, we expect to incur costs up to $15.0 million to consolidate certain facilities and eliminate redundant employees, of which $9.8 million has been incurred to date. The amount of costs ultimately incurred will depend on our ability to recover ongoing lease costs for vacant facilities by subleasing such facilities to third parties.
Due to completion of all actions under restructuring plans initiated prior to 2011 and immateriality of the remaining accrual balance related to such plans, these plans have been combined for disclosure purposes. We expect to incur restructuring costs in future periods associated primarily with vacant facilities until such time as those facilities have been sold or leased to third parties.
Below is a summary of restructuring costs associated with facility closures and other consolidation efforts that were initiated prior to 2011:
Costs incurred with respect to facilities consist primarily of 1) costs to maintain vacant facilities that are owned until such facilities can be sold and 2) the portion of our lease payments that have not been recovered due to the absence of sublease income for vacant leased properties. We expect to pay the majority of accrued restructuring costs by September 2012.
Gain on Sales of Long-lived Assets
For the three and nine months ended July 2, 2011, we recorded gains on sales of long-lived assets of $1.4 million and $3.5 million, respectively. For the three and nine months ended July 3, 2010, we recorded gains on sales of long-lived assets of $13.8 million. These gains were primarily related to the sale of certain properties held-for-sale.
Interest expense decreased to $24.8 million for the three months ended July 2, 2011, from $27.1 million for the three months ended July 3, 2010, and to $77.8 million for the nine months ended July 2, 2011, from $80.5 million for the nine months ended July 3, 2010. The decrease for both periods was primarily attributable to a net reduction of $80 million in our long-term debt and the favorable impact of replacing $580 million of fixed-rate debt with $500 million of lower variable rate debt.
Other Income (Expense), net
The following table presents the major components of other income (expense), net:
We reduce our exposure to currency fluctuations through the use of foreign currency hedging instruments; however, hedges are established based on forecasts of foreign currency transactions. To the extent actual amounts differ from forecasted amounts, we will have exposure to currency fluctuations, resulting in foreign exchange gains or losses.
(1) Amount is $2.2 million less than that reported in our earnings release due to a correction identified after the earnings release.
Provision for Income Taxes
We estimate our annual effective tax rate at the end of each quarterly period. Our estimate takes into account the geographic mix of our expected pre-tax income (loss), expected total annual pre-tax income (loss), implementation of tax planning strategies and possible outcomes of audits and other uncertain tax positions. To the extent there are fluctuations in any of these variables during a period, our provision for income taxes may vary.
Our provision for income taxes was an expense of $19.9 million for the nine months ended July 2, 2011, compared to an expense of $14.4 million for the nine months ended July 3, 2010. Despite lower pre-tax income in 2011, our year-to-date tax provision is higher than the amount for the comparable period in 2010 primarily as a result of favorable resolution of an uncertain tax position in 2010.
Liquidity and Capital Resources
Key liquidity performance measures
(1) Days sales outstanding (a measure of how quickly we collect our accounts receivable), or DSO, is calculated as the ratio of average accounts receivable, net, to average daily net sales for the quarter.
(2) Inventory turns (annualized) are calculated as the ratio of four times our cost of sales for the quarter to average inventory.
(3) Accounts payable days (a measure of how quickly we pay our suppliers) is calculated as the ratio of 365 days divided by accounts payable turns, in which accounts payable turns is calculated as the ratio of four times our cost of sales for the quarter to average accounts payable.
(4) Cash cycle days is calculated as the ratio of 365 days to inventory turns, plus days sales outstanding minus accounts payable days.
Cash and cash equivalents were $582.8 million at July 2, 2011 and $592.8 million at October 2, 2010. Our cash levels vary during any given quarter depending on the timing of collections from customers and payments to suppliers, borrowings under credit facilities and other factors. Our working capital was $1.4 billion as of July 2, 2011 and $1.3 billion as of October 2, 2010.
Net cash provided by (used in) operating activities was $155.9 million and $(44.4) million for the nine months ended July 2, 2011 and July 3, 2010, respectively. For the nine months ended July 2, 2011, cash flows from operating activities consist of: 1) net inflows of $152.7 million from net income adjusted to exclude non-cash items such as depreciation and amortization, stock-based compensation expense, etc., and 2) net inflows of $3.2 million from changes in net operating assets, which are comprised of accounts receivable, inventories, prepaid expenses and other assets, accounts payable, and accrued liabilities and other long-term liabilities.
During the nine months ended July 2, 2011, we generated $3.2 million of cash from the reduction of our net operating assets. Accounts payable increased $42.1 million, versus a $39.2 million increase in inventories. This is a result of a decrease in accounts payable days from 55 days at October 2, 2010 to 54 days at July 2, 2011. The decrease resulted primarily from a change in the composition of our accounts payable from suppliers with longer payment terms to suppliers with shorter payment terms. Despite a slight decrease in revenue in the third quarter of 2011 versus the fourth quarter of 2010, accounts receivable increased $19.9 million as a result of a longer collection cycle caused by a change in the composition of our accounts receivable from customers with shorter payment terms to customers with longer payment terms. This change resulted in our
DSO increasing from 52 days at October 2, 2010 to 54 days at July 2, 2011. The increase in accounts receivable was mitigated by an increase in accrued liabilities and a decrease in prepaid expenses and other assets. Our working capital metrics tend to fluctuate from quarter-to-quarter based on factors such as the linearity of our shipments and purchases, customer and supplier mix, and the negotiation of payment terms with customers and suppliers. These fluctuations can significantly affect our cash flows from operating activities.
Net cash used in investing activities was $73.7 million