FCS Fairchild Semiconductor International, Inc. (MM)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 1 – Basis of Presentation

The accompanying interim consolidated financial statements of Fairchild Semiconductor International, Inc. (“Fairchild Semiconductor”, “we”, “our” or “ the company”) have been prepared in conformity with accounting principles generally accepted in the United States of America, consistent in all material respects with those applied in our Annual Report on Form 10-K for the year ended December 27, 2015. The interim financial information is unaudited, but reflects all normal adjustments, which are, in the opinion of management, necessary to provide a fair statement of results for the interim periods presented. The financial statements should be read in conjunction with the financial statements in our Annual Report on Form 10-K for the year ended December 27, 2015. Our accounting policies are described in the “Notes to Consolidated Financial Statements” in our Annual Report on Form 10-K and updated, as necessary, in Form 10-Q. The results for the interim periods are not necessarily indicative of the results of operations that may be expected for the full year.

Our fiscal calendar, in which each quarter ends on a Sunday, contains 53 weeks every seven years compared to the usual 52 weeks. This additional week is included in the first quarter of the year. Our results for the three months ended June 26, 2016 and June 28, 2015 both consisted of 13 weeks. Our results for the six months ended June 26, 2016 and June 28, 2015 both consisted of 26 weeks.

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. (U.S. GAAP) requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Such estimates include the valuation of accounts receivable, inventories, goodwill, investments, intangible assets and other long-lived assets, business combinations, loss contingencies, and assumptions used in the calculation of income taxes, valuation of deferred tax assets, and customer incentives, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, volatile equity, foreign currency markets, and declines in consumer spending have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.

Pending Acquisition

On November 18, 2015, Fairchild Semiconductor entered into an Agreement and Plan of Merger (the “Merger Agreement”) with ON Semiconductor Corporation and its wholly owned subsidiary, Falcon Operations Sub, Inc. (together, “ON Semiconductor”), under which ON Semiconductor agreed to acquire Fairchild Semiconductor. The total transaction value is expected to be approximately $2.4 billion. Under the terms of the Merger Agreement, on December 4, 2015, ON Semiconductor commenced a tender offer to acquire outstanding shares of Fairchild Semiconductor common stock from our stockholders for $20.00 per share, net to each holder in cash (the “Offer Price”). The tender offer is described in a Tender Offer Statement on Schedule TO filed by ON Semiconductor with the Securities and Exchange Commission on December 4, 2015 (as amended, the “ON Schedule TO”). The closing of the tender offer is subject to various conditions, including there being validly tendered in the tender offer at least a majority of our then-outstanding shares, and the receipt of customary regulatory approvals in the U.S. and other countries. Following receipt of those approvals and after such time as all shares tendered in the tender offer are accepted for payment, the Merger Agreement provides for the parties to effect a merger which would result in all shares not tendered in the tender offer (other than shares held by (i) ON Semiconductor, Fairchild Semiconductor or their respective subsidiaries immediately prior to the effective time of the merger, and (ii) stockholders of Fairchild Semiconductor who properly exercised their appraisal rights under the Delaware General Corporation Law) being converted into the right to receive the Offer Price. In addition, immediately prior to the effective time of the merger, all outstanding options to purchase shares of Fairchild Semiconductor common stock, restricted stock units, deferred stock units and performance units will become fully vested and be converted into the right to receive the Offer Price (net of any applicable exercise price with respect to options).

At the completion of the merger, Fairchild Semiconductor would become a wholly-owned subsidiary of ON Semiconductor. Additional information about our pending acquisition by ON Semiconductor is available in the Solicitation/Recommendation Statement on Schedule 14D-9 filed with the Securities and Exchange Commission by Fairchild Semiconductor International, Inc. (as amended, our “Schedule 14D-9”). The foregoing description of the Merger Agreement and the terms and conditions of the tender offer and merger do not purport to be complete and are qualified in their entirety by reference to the Merger Agreement, to our Schedule 14D-9, and to ON Semiconductor’s tender offer to purchase and other related documents, copies of which are filed as Exhibits (e)(1) and (a)(1)(A), respectively, of our Schedule 14D-9, all of which are incorporated herein by reference. The Merger Agreement is also filed as Exhibit 2.01 to our Annual Report on Form 10-K for the year ended December 27, 2015. The transaction is expected to close in the third quarter of 2016.

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Note 2 – Fair Value Measurements

The assets and liabilities measured at fair value on a recurring basis include securities and derivatives. Financial instruments classified as Level 1 are securities traded on an active exchange as well as U.S. Treasury, and other U.S. government and agency-backed securities that are traded by dealers or brokers in active over-the-counter markets. The fair value of securities is based on quoted market prices at the date of measurement.

All of our derivatives are traded in over-the-counter markets where quoted market prices are not readily available. For these derivatives, we measured fair value utilizing a third-party pricing service. The pricing service utilizes industry standard valuation models, including both income and market-based approaches and observable market inputs to determine value. These observable market inputs include reportable trades, benchmark yields, credit spreads, broker/dealer quotes, bids, offers, current spot rates and other industry and economic events. Accordingly, the fair value of these assets is classified as Level 2 within the fair value hierarchy.

We do not have any financial instruments classified as Level 3.

The tables below present information about our assets and liabilities that are regularly measured and carried at fair value and indicate the level within the fair value hierarchy of the valuation techniques we utilized to determine such fair value:

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The fair values of our debt instruments, which are classified as Level 2, are carried at amortized cost. The carrying amount of the revolving credit facility is considered to approximate fair value as the interest rate on the loan is in line with current market rates. Please refer to  Note 8. Indebtedness   to our Annual Report in form 10-K for the year ended December 27, 2015 for further information about our revolving credit facility.

The amortized cost and estimated fair value of our marketable securities available-for-sale by contractual maturity are summarized as follows:

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Note 4 – Derivatives

We used derivative instruments in the first six months of 2016 and fiscal year 2015 to manage exposures to changes in foreign currency exchange rates. The fair value of these hedges is recorded on the balance sheet. Please refer to Note 2 Fair Value Measurements for further information about the fair value of derivatives.

Foreign Currency Forward Contracts - Hedging Instruments

We used foreign currency forward contracts in the first six months of 2016 and fiscal year 2015 to hedge a portion of our forecasted foreign exchange denominated revenues and expenses. We monitor our foreign currency exposures in an effort to maximize the overall effectiveness of our foreign currency hedge positions. Our objective for holding derivatives is to minimize the risks using the most effective methods to eliminate or reduce the impacts of these exposures. The maturities of the hedges are 6 months or less as of the end of June 26, 2016. We have not entered into any new foreign currency forward contracts during the first six months of 2016.

Changes in the fair value of derivative instruments related to time value are included in the assessment of hedge effectiveness. Hedge ineffectiveness did not have a material impact on earnings for the six months ended June 26, 2016.

Derivative gains and losses included in AOCI are reclassified into earnings at the time the forecasted transaction is recognized. For derivative transactions related to inventory, the effective portion of foreign exchange gains and losses deferred in AOCI is reclassified into earnings as the underlying inventory is sold, using historical inventory turnover rates. We estimate that $0.2 million of net unrealized derivative losses included in AOCI will be reclassified into earnings within the next six months.

The following tables present derivatives designated as hedging instruments:

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The following tables present derivatives not designated as hedging instruments.

We net the fair value of all derivative financial instruments with counter-parties for which a master netting arrangement is utilized.

The gross amounts of the derivative assets and liabilities are as follows:

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Assets classified as held for sale are required to be recorded at the lower of carrying value or fair value less any costs to sell. The carrying value of these assets, as of the second quarter of 2016 and the fourth quarter of 2015 was $12.5 million and $15.4 million, respectively and are reported in the other current assets line of our statement of financial position. The reduction in carrying value of $2.9 million is discussed in Note 9 Restructuring, Impairments and Other Costs . We expect to dispose of the remaining assets within the next twelve months.

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Note 6 – Goodwill and Intangible Assets

Our total goodwill balances were $205.9 million and $204.5 million at June 26, 2016 and December 27, 2015, respectively. The difference between the two periods relates to foreign exchange impacts of $1.4 million. Please refer to  Note 7. Goodwill and Intangible Assets   to our Annual Report in form 10-K for the year ended December 27, 2015 for more information regarding our accumulated impairment losses and goodwill balances.

The following table presents the carrying amount of goodwill by reportable segment:

The following table presents a summary of acquired intangible assets:

Amortization expense for intangible assets was $3.8 million and $4.2 million for the six months ended June 26, 2016 and June 28, 2015, respectively.

The estimated amortization expense for intangible assets for each of the five succeeding fiscal years is as follows:

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Revolving Credit Facility

On September 26, 2014, we entered into our current $400.0 million, five-year senior secured revolving credit facility. Please refer to  Note 8. Indebtedness   to our Annual Report in form 10-K for the year ended December 27, 2015 for further information about our revolving credit facility.

After adjusting for outstanding letters of credit, we have $199.3 million available under the credit facility as of June 26, 2016. We have additional outstanding letters of credit of $0.4 million that do not fall under the credit facility as of June 26, 2016. We also have $3.7 million of undrawn credit facilities at certain of our foreign subsidiaries as of June 26, 2016. These outstanding amounts do not impact available borrowings under the credit facility.

Note 8 – Contingencies

Litigation

From time to time, the company is involved in legal proceedings in the ordinary course of business. We analyze potential outcomes from current and potential litigation as loss contingencies in accordance with U.S. GAAP. Since most potential claims against the company may involve the enforcement of complex intellectual property rights or complicated damages calculations, we generally cannot predict the eventual outcome of pending matters, the timing of the ultimate resolution of these matters, or the magnitude of the eventual loss related to each pending matter.

For a limited number of matters disclosed in this note for which a loss, whether in excess of a related accrued liability or where there is no accrued liability, is reasonably possible in future periods, we estimate a range of possible loss. In determining whether it is possible to estimate a range of possible loss, we review and evaluate our material litigation on an ongoing basis in light of potentially relevant factual and legal developments. These may include information learned through the discovery process, legal analysis and opinions of counsel, rulings on motions, settlement discussions, and other rulings by courts, arbitrators or others. If we possess sufficient information to develop an estimate of loss or range of possible loss, that estimate is disclosed either individually or in the aggregate. Finally, for loss contingencies for which we believe the possibility of loss is remote, we do not record a reserve or assess the range of possible losses.

Based on current knowledge, management does not believe that loss contingencies arising from pending matters will have a material adverse effect on our business, financial condition, results of operations or cash flows. However, in light of the inherent uncertainties involved in these matters, some of which are beyond our control, an adverse outcome in one or more of these matters could be material to our results of operations or cash flows for any particular reporting period.

Patent Litigation with Power Integrations, Inc.

There are five outstanding proceedings with Power Integrations.

POWI 1 : On October 20, 2004, the company and its wholly owned subsidiary, Fairchild Semiconductor Corporation, were sued by Power Integrations, Inc. in the U.S. District Court for the District of Delaware. Power Integrations alleged that certain of the company’s pulse width modulation (PWM) integrated circuit products infringed four Power Integrations U.S. patents, and sought a permanent injunction preventing the company from manufacturing, selling or offering the products for sale in the U.S., or from importing the products into the U.S., as well as money damages for past infringement.

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The trial in the case was divided into three phases. In the first phase of the trial that occurred in October of 2006, a jury returned a verdict finding that thirty-three of the company’s PWM products willfully infringed one or more of seven claims asserted in the four patents and assessed damages against the company. The company voluntarily stopped U.S. sales and importation of those products in 2007 and has been offering replacement products since 2006. Subsequent phases of the trial conducted during 2007 and 2008 focused on the validity and enforceability of the patents. In December of 2008, the judge overseeing the case reduced the jury’s 2006 damages award from $34.0 million to approximately $6.1 million and ordered a new trial on the issue of willfulness. Following the new trial held in June of 2009, the court found the company’s infringement to have been willful, and in January 2011 the court awarded Power Integrations final damages in the amount of $12.2 million. The company appealed the final damages award, willfulness finding, and other issues to the U.S. Court of Appeals for the Federal Circuit. In March 2013, the court of appeals vacated almost the entire damages award, ruling that there was no basis upon which a reasonable jury could find the company liable for induced infringement. The court also vacated the earlier judgment of willful patent infringement by the company. The full court of appeals and the Supreme Court of the United States have since denied Power Integrations’ requests to review the appeals court ruling. Although the appeals court instructed the lower court to conduct further proceedings to determine damages based upon approximately $500,000 to $750,000 worth of sales and imports of affected products, the company believes that damages on the basis of that level of infringing activity would not be material. Accordingly, the company released $12.6 million from its reserves relating to this case during the first quarter of 2013.

POWI 2 : In May 2008, Power Integrations filed another lawsuit against the company, Fairchild Semiconductor Corporation and its wholly owned subsidiary, System General Corporation (now named Fairchild (Taiwan) Corporation), in the U.S. District Court for the District of Delaware, alleging infringement of three patents. Of the three patents asserted in that lawsuit, two were asserted against the company and Fairchild Semiconductor Corporation in the October 2004 lawsuit described above. In 2011, Power Integrations added a fourth patent to this case.

In October 2008, Fairchild Semiconductor Corporation and System General Corporation filed a patent infringement lawsuit against Power Integrations in the U.S. District Court for the District of Delaware, alleging that certain PWM integrated circuit products infringe one or more claims of two U.S. patents owned by System General. The lawsuit seeks monetary damages and an injunction preventing the manufacture, use, sale, offer for sale or importation of Power Integrations products found to infringe the asserted patents.

Both lawsuits were consolidated and heard together in a jury trial in April of 2012. The jury found that Power Integrations infringed one of the two U.S. patents owned by System General and upheld the validity of both System General patents. In the same verdict, the jury found that the company infringed two of four U.S. patents asserted by Power Integrations and that the company had induced its customers to infringe the asserted patents. (The court later ruled that the company infringed one other asserted Power Integrations patent that the jury found was not infringed.) The jury also upheld the validity of the asserted Power Integrations patents. The verdict concluded the first phase of trial in this case. On June 30, 2014, the court issued an order enjoining Fairchild from making, using, selling, offering to sell or importing into the United States the products found to infringe the Power Integrations patents in the case as well as certain products that were similar to the products found to infringe. Willfulness and damages in the case will be determined in a second phase, which has yet to be scheduled and will occur after appeals of the first phase. The company and Power Integrations have filed appeals from the first phase. These appeals were argued before the U.S. Court of Appeals for the Federal Circuit on July 8, 2016. A ruling on the appeals is expected in the next several months.

POWI 3 : On November 4, 2009, Power Integrations filed another patent infringement lawsuit against the company, Fairchild Semiconductor Corporation and its wholly owned subsidiary, System General Corporation (now named Fairchild (Taiwan) Corporation), in the U.S. District Court for the Northern District of California alleging that several of its products infringe three of Power Integrations’ patents. Fairchild filed counterclaims asserting that Power Integrations infringes two Fairchild patents. A trial was held February 2014 on two Power Integrations’ patents and one Fairchild patent. On March 4, 2014, a jury returned a verdict finding that Fairchild willfully infringed both Power Integrations patents, awarding Power Integrations $105.0 million in damages, and finding that Power Integrations did not infringe the Fairchild patent. Both parties filed various post-trial motions, which were denied by the court with the exception of Fairchild’s motion to set aside the jury’s determination that it acted willfully. The court granted the company’s motion and determined that, as a matter of law, Fairchild’s actions were not willful.

In addition to the ruling on willfulness, the company continued to challenge several other aspects of the verdict during post-trial review. Specifically, the company asserted that the damages award included legal and evidentiary defects that were inconsistent with rulings by the U.S. Court of Appeals for the Federal Circuit. On November 25, 2014, the trial court ruled that the jury lacked sufficient evidence on which to base its damages award and, consequently, vacated the $105.0 million verdict and ordered a second trial on damages. The court later denied Power Integrations’ request to enjoin the Fairchild products that were found to infringe, finding, among other things, that the evidence at trial failed to establish a causal connection between the alleged harm and the alleged infringement. The court ruled that Power Integrations can request an injunction after the second trial on damages. The second damages trial was held in December 2015. On December 17, 2015, a jury returned a verdict awarding Power Integrations $139.8 million in damages. The company has filed a number of post-trial motions challenging the verdict on several grounds, including several that are similar to challenges to the earlier damages verdict in the case. If the current damages award is not vacated or significantly reduced in post-trial proceedings, the company plans to appeal the current damages award. The company also plans to appeal the 2014 verdict finding that the asserted Power Integrations’ patents were infringed and valid.

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POWI 4 : In May 2012, the company sued Power Integrations in the U.S. District Court for the District of Delaware. The lawsuit accuses Power Integration’s LinkSwitch-PH LED power conversion products of violating three of the company’s patents. Power Integrations filed counterclaims of patent infringement against the company, asserting five Power Integrations patents. Of those five patents, the court granted Fairchild summary judgment of no infringement on one, Power Integration voluntarily withdrew a second and was forced to remove a third patent during the trial. In June 2015, a jury found that Power Integrations induced infringement of Fairchild’s patent rights, and awarded Fairchild $2.4 million in damages. The same jury found that Fairchild did not infringe one of the two remaining Power Integrations patents, found that Fairchild infringed two claims of the last Power Integrations patent, and awarded Power Integrations damages of $0.1 million. On July 15, 2016, Fairchild filed a motion for a permanent injunction that, if granted, would prohibit Power Integrations from making, using, selling, offering to sell or importing into the United States the Power Integrations products found to infringe the Fairchild patent, which were the basis for the jury’s inducement finding. In the alternative, Fairchild asked the court to determine an ongoing royalty applicable to sales of the Power Integrations products found to infringe. Those motions are pending before the court.

POWI 5: On October 21, 2015, Power Integrations filed another complaint for patent infringement against Fairchild Semiconductor International, Inc., Fairchild Semiconductor Corporation and Fairchild (Taiwan) Corporation in the U.S. District Court for the Northern District of California. The lawsuit alleges certain products infringe two Power Integrations patents. The company is vigorously defending the lawsuit, which is in its earliest stages.

Other Legal Claims

From time to time we are involved in legal proceedings in the ordinary course of business. We believe we have valid defenses with respect to matters currently pending against us and we intend to vigorously defend against those claims. For example, in December 2013, a customer of one of our distributors filed suit against us claiming damages of $30.0 million arising out of the purchase of $20,000 of our products. We are contesting that claim vigorously. We believe there is no such ordinary-course pending litigation that could have, individually or in the aggregate, a material adverse effect on our business, financial condition, results of operations, or cash flows.

For matters where an estimate of the range of possible loss is reasonably possible, management currently estimates the aggregate range of reasonably possible loss, in excess of amounts accrued for outstanding matters, is $1.2 million to $18.4 million. The estimated range of reasonably possible loss is based upon currently available information and is subject to significant judgment and a variety of assumptions, and known and unknown uncertainties. The matters underlying the estimated range will change from time to time, and actual results may vary significantly from the current estimate. Those matters for which an estimate is not possible are not included within this estimated range. Therefore, this estimated range of possible loss represents what we believe to be an estimate of possible loss only for certain matters meeting these criteria. It does not represent our maximum exposure.

Note 9 – Restructuring, Impairments and Other Costs

During the three months ended June 26, 2016 and June 28, 2015, we recorded restructuring, impairment and other costs, net of releases and gains of $0.6 million and $4.2 million, respectively. During the six months ended June 26, 2016 and June 28, 2015, we recorded restructuring, impairment and other costs, net of releases and gains of $(10.3) million and $8.9 million, respectively. The detail of the charges for the three and six months ended June 26, 2016 is presented in the summary table below.

2015 Operating Expense Reduction Program

In the third quarter of 2015, we announced a program to reduce operating expenses by approximately $30.0 million to $34.0 million annually. This is a structural change to the operating expense level of the company and the anticipated savings contain no temporary measures. We recorded $12.9 million of employee separation expense in 2015, which represents the full cost of this program. This program is substantially complete as of June 26, 2016.

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Prior Year Infrastructure Realignment Programs

The 2014 Infrastructure Realignment Program consists of product line and sales organizational changes, costs associated with streamlining operations creating greater manufacturing flexibility and having a more balanced internal versus external production mix, and other related costs mainly associated with product qualification activities. In 2014, we announced our 2014 Manufacturing Footprint Consolidation Plan. We eliminated our internal 5-inch and significantly reduced 6-inch wafer fabrication lines and rationalized our assembly and test capacity, resulting in the closure of our manufacturing and assembly facilities in West Jordan, Utah and Penang, Malaysia, as well as the remaining 5-inch wafer fabrication lines in Bucheon, South Korea. We ended production at these sites during the third quarter of fiscal year 2015. In the first quarter of 2016, we sold the facility in Penang, Malaysia for a gain of $12.3 million, which is reflected in the table below within the asset disposal (gain) loss caption.

In addition to the amounts recorded in the summary below, we expect to incur an additional $1 million in site closure costs to complete this program in fiscal year 2016.

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