ACME UNITED CORP 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Information The Company may from time to time make written or oral “forward-looking statements” including statements contained in this report and in other communications by the Company, which are made in good faith pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Such statements are based on our beliefs as well as assumptions made by and information currently available to us. When used in this document, words like “may,” “might,” “will,” “except,” “anticipate,” “believe,” “potential,” and similar expressions are intended to identify forward-looking statements. Actual results could differ materially from our current expectations. Forward-looking statements in this report, including without limitation, statements related to the Company’s plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties that may impact the Company’s business, operations and financial results, including those risks and uncertainties resulting from the global COVID-19 pandemic, future waves of COVID-19, including through the Delta and Omicron variants and any new variant strains of the underlying virus; any future pandemics; the continuing effectiveness, global availability, and public acceptance of existing vaccines; the effectiveness, availability, and public acceptance of vaccines against variant strains of potential new viruses; and the heightened impact the pandemic has on many of the risks described herein, including, without limitation, risks relating to disruptions in our domestic and global supply chains, and labor shortages, any of which could materially adversely impact the Company’s ability to manufacture, source or distribute its products, both domestically and internationally. These risks and uncertainties further include, without limitation, the following: (i) changes in the Company’s plans, strategies, objectives, expectations and intentions, which may be made at any time at the discretion of the Company; (ii) the impact of uncertainties in global economic conditions, whether caused by COVID-19 or otherwise, including the impact on the Company’s suppliers and customers; (iii) additional disruptions in the Company’s supply chains, whether caused by COVID-19, the war in Ukraine, or otherwise, including trucker shortages, port closures and delays, and delays with container ships themselves; (iv) labor shortages and related costs the Company has and may continue to incur, including costs of acquiring and training new employees and rising wages and benefits; (v) the continuing adverse impact of inflation, including product costs, and transportation costs; (vi) currency fluctuations including, for example, the increasing strength of the dollar against the euro: the Company’s ability to effectively manage its inventory in a rapidly changing business environment, including the additional inventory the Company has acquired in anticipation of supply chain disruptions and uncertainties; (vii) changes in client needs and consumer spending habits; (viii) the impact of competition; (ix) the impact of technological changes including, specifically, the growth of online marketing and sales activity; (x) the Company’s ability to manage its growth effectively, including its ability to successfully integrate any business it might acquire; (xi) international trade policies and their impact on demand for our products and our competitive position, including the imposition of new tariffs or changes in existing tariff rates; and (xiii) other risks and uncertainties indicated from time to time in the Company’s filings with the Securities and Exchange Commission. For a more detailed discussion of these and other factors affecting the Company, see the Risk Factors described in Item 1A included in this Annual Report on Form 10-K and below under “Financial Condition”. All forward-looking statements in this report are based upon information available to the Company on the date of this report. The Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, or otherwise, except as required by law. Critical Accounting Policies & Estimates The following discussion and analysis of financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in conformity with generally accepted accounting principles in the United States of America. The Company’s significant accounting policies are more fully described in Note 2 of the notes to consolidated financial statements. Certain accounting estimates are particularly important to the understanding of the Company’s financial position and results of operations and require the application of significant judgment by the Company’s management and can be materially affected by changes from period to period in economic factors or conditions that are outside the control of management. The Company’s management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on historical operations, future business plans and projected financial results, the terms of existing contracts, the observance of trends in the industry, information provided by customers and information available from other outside sources, as appropriate. The following discusses the Company’s critical accounting policies and estimates: Estimates – Operating results may be affected by certain accounting estimates. The most sensitive and significant accounting estimates in the financial statements relate to customer rebates, valuation allowances for deferred income tax assets, obsolete and slow-moving inventories, potentially uncollectible accounts receivable, intangibles and stock-based compensation. Although the Company’s management has used available information to make judgments on the appropriate estimates to account for the above matters, there can be no assurance that future events will not significantly affect the estimated amounts related to these areas where estimates are required. However, historically, actual results have not been materially different than original estimates. Revenue Recognition – The Company's revenues result from the sale of goods or services and reflect the consideration to which the Company expects to be entitled. The Company records revenue based on a five-step model in accordance with Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"). For its contracts with customers, the Company identifies the performance obligations (goods or services), determines the transaction price, allocates the contract transaction price to the performance obligations, and recognizes the revenue when (or as) the performance obligation is transferred to the customer. A good or service is transferred when (or as) the customer obtains control of that good or service. Depending on the contractual terms of each customer, revenue is recognized either at the time of shipment “FOB Shipping Point” or upon delivery “FOB Destination". When revenue is recorded, estimates of returns are made and recorded 16 as a reduction of revenue. Customer rebates and incentives earned based on promotional programs in place volume of purchases or other factors are also estimated at the time of revenue recognition and recorded as a reduction of that revenue. Refer to Note 9 – Revenue from Contracts with Customers , in the notes to consolidated financial statements in this report for a more detailed discussion . Allowance for Doubtful Accounts – The Company provides an allowance for doubtful accounts based upon a review of outstanding accounts receivable, historical collection information and existing economic conditions. The allowance for doubtful accounts represents estimated uncollectible accounts receivables associated with potential customer defaults on contractual obligations, usually due to potential insolvencies. The allowance includes amounts for certain customers where a risk of default has been specifically identified. In addition, the allowance includes a provision for customer defaults based on historical experience. The Company actively monitors its accounts receivable balances, and its historical experience of annual accounts receivable write-offs has been negligible. Customer Rebates – Customer rebates and incentives are a common practice in the office products industry. We incur customer rebate costs to obtain favorable product placement, to promote sell-through of products and to maintain competitive pricing. Customer rebate costs and incentives, including volume rebates, promotional funds, catalog allowances and slotting fees, are accounted for as a reduction to gross sales. These costs are recorded at the time of sale and are based on individual customer contracts. Management periodically reviews accruals for these rebates and allowances and adjusts accruals when appropriate. Obsolete and Slow Moving Inventory – Inventories are stated at the lower of cost or net realizable value. Cost of inventories is determined by the first-in, first-out method. An allowance is established to adjust the cost of inventory to its net realizable value. Inventory allowances are recorded for obsolete or slow moving inventory based on assumptions about future demand and marketability of products, the impact of new product introductions and specific identification of items, such as discontinued products. These estimates could vary significantly from actual requirements if future economic conditions, customer inventory levels or competitive conditions differ from expectations. Income Taxes – Deferred income tax liabilities or assets are established for temporary differences between financial and tax reporting bases and are subsequently adjusted to reflect changes in tax rates expected to be in effect when the temporary differences reverse. A valuation allowance is recorded to reduce deferred income tax assets to an amount that is more likely than not to be realized. Intangible Assets and Goodwill – Intangible assets with finite useful lives are recorded at cost upon acquisition and amortized over the term of the related contract, if any, or useful life, as applicable. Intangible assets held by the Company with finite useful lives include patents and trademarks. The weighted average amortization period for intangible assets at December 31, 2022 was 9 years. The Company periodically reviews the values recorded for intangible assets and goodwill to assess recoverability from future operations whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. At December 31, 2022 and 2021, the Company assessed the recoverability of its long-lived assets and goodwill and believed that there were no events or circumstances present that would require a test of recoverability on those assets. As a result, there was no impairment of the carrying amounts of such assets and no reduction in their estimated useful lives. Contingent Consideration - As part of the acquisition of Safety Made, a $1.5 million payment will be due, contingent on the acquired business meeting certain revenue milestones over a two-year period, commencing on the date of the acquisition. The fair value of the contingent liability at each reporting date is based on certain estimates and judgements made by management. Those estimates are made from the most relevant data available at that time and include historical data and future projections. At December 31, 2022, the fair value of the contingent consideration was $1,330,000. Accounting for Stock-Based Compensation – Stock based compensation cost is measured at the grant date fair value of the award and is recognized as expense over the requisite service period. The Company uses the Black-Scholes option - pricing model to determine fair value of the awards, which involves certain subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (“expected term”), the estimated volatility of the Company’s common stock price over the expected term (“volatility”) and the number of options for which vesting requirements will not be completed (“forfeitures”). Changes in the subjective assumptions can materially affect estimates of fair value stock-based compensation, and the related amount recognized on the consolidated statements of operations. Refer to Note 11 – Stock Option Plans, in the notes to consolidated financial statements in this report for a more detailed discussion. Results of Operations 2022 Compared with 2021 Traditionally, the Company’s sales and profits are stronger in the second and third quarters and weaker in the first and fourth quarters of the fiscal year, due to the seasonal nature of the Westcott back-to-school market. Macroeconomic, Supply Chain and Related Considerations The global macroeconomic environment has continued to be challenging in 2022, characterized by global inflation at multi-decade highs, rising interest rates, and significant currency fluctuations. These factors have exacerbated an economy that was struggling to recover from the COVID-19 pandemic. During 2022, the Company experienced significant supply chain issues. In anticipation of potential supply chain disruptions, the Company had purchased and maintained additional inventory to minimize the impact of any disruption in our supply chain. However, as economies have become less restricted by the COVID pandemic, global supply chains have struggled to keep up with increasing demand, and the resulting supply chain disruptions have significantly increased costs. The supply chain issues caused exceptional ocean and inland freight and demurrage 17 costs. The freight and demurrage costs began to decrease in the third quarter of 2022. We recognize those expenses as products are sold and, as a result, the unusually high freight and demurrage costs continued to adversely impact our results for the quarter s ended September 30 , 2022 and December 31 , 2022 and had an overall adverse effect on our operating margin for the twelve months of 2022. In addition, the war in Ukraine is causing a slowdown in the European economy. This softness, coupled with a historically low exchange rate for the Euro, has led to challenges in our European markets which we anticipate will continue for at least the near future. Any continuation of supply chain issues, continued high inflation, currency fluctuations, high interest rates, and any further increase in the duration or severity of the COVID-19 pandemic or a resurgence of the pandemic might continue to adversely affect the Company’s business, operations and financial condition. The impact of these developments is highly uncertain and cannot be predicted. Net Sales In 2022, sales increased by $11,874,798, or 7%, to $193,962,357 compared to $182,087,559 in 2021. The U.S. segment sales increased by 8%, in 2022 compared to 2021. The large majority of the increase was attributable to strong sales of first aid and medical products, primarily due to continued market share gains in the industrial, mass market and e-commerce channels as well as sales coming from the Safety Made acquisition. European net sales for the year ended December 31, 2022, decreased 2% in U.S. dollars but increased 10% in local currency, compared with the same period in 2021. The increase was mainly due to market share gains in Westcott cutting products. Net sales in Canada for the year ended December 31, 2022, decreased 4% in U.S. dollars and were constant in local currency compared to the same period in 2021. Gross Profit Gross profit was $63,558,785 (32.8% of net sales) in 2022 compared to $64,800,357 (35.6% of net sales) in 2021. The decline was primarily due to exceptionally high ocean container costs and demurrage charges (1.7% impact). Also contributing to the decline in gross profit were weaker currencies in Europe and Canada, where we purchase most of our inventory in U.S. dollars. Selling, General and Administrative Selling, general and administrative (“SG&A”) expenses were $57,285,483 in 2022 compared with $52,030,370 in 2021, an increase of $5,255,113, or 10.1%. SG&A expenses were 29.5% of net sales in 2022 compared to 28.6% in 2021. Approximately 34% of the increase in SG&A expenses was due to higher personnel related costs. Approximately 31% of the increase was due to higher commissions and shipping costs related to higher sales. The increased shipping costs included fuel surcharges due to higher gas prices in the first half of 2022. The remaining increase was mainly due to Safety Made related ordinary S,G&A expenses. Operating Income Operating income was $6,273,302 in 2022, compared with $12,769,987 in 2021, a decrease of $6,496,685. Operating income in the U.S. segment decreased in 2022 by approximately $4,750,000 compared to 2021, primarily due to increased supply chain costs which include exceptionally high ocean container costs and demurrage charges. $3.3 million of exceptional supply chain costs were recognized in 2022 compared to $0 in 2021. Operating income in the European segment decreased by $1,000,000 compared to 2021 primarily due to increased supply chain costs as well as a weaker currency in Europe where we purchase most of our inventory in U.S. dollars. $700,000 of exceptional supply chain costs were recognized in 2022 compared to $0 in 2021. Operating income in Canada decreased in 2022 by approximately $757,000 compared to 2021, primarily due to higher inbound and outbound freight. Interest Expense, Net Net interest expense for 2022 was $2,364,461, compared with $908,223 for 2021, an increase of $1,456,238. The increase in net interest expense resulted from a higher average interest rate on the outstanding debt as well as higher average debt outstanding under the Company’s revolving loan agreement. The weighted average interest rate in 2022 was 3.8% compared to 2.1% in 2021. Other Expense Other expense was $246,396 in 2022 compared to $194,877 in 2021. The increase in total other expense was due to losses from foreign currency transactions, primarily due to a declining Euro in our European business. 18 Income Tax Expense Income tax expense was $627,679 in 2022, resulting in an effective tax rate of 17% compared to $1,519,255, an effective tax rate of 10% in 2021. Income tax expense in 2021 included a $1.4 million tax credit for stock-based compensation. The Company’s effective tax rate in 2021, excluding the tax credit and the income from the PPP Loan forgiveness was 24%. The lower effective tax rate in 2022 was due to a lower proportion of earnings in jurisdictions with a higher tax rate. Off-Balance Sheet Transactions The Company did not engage in any off-balance sheet transactions during 2022. Liquidity and Capital Resources During 2022, working capital increased by approximately $8.5 million compared to December 31, 2021. Inventory increased by approximately $9.7 million, or 18%. We increased inventory during 2022 to anticipate our continued growth and to be positioned to offset the impact of potential supply chain disruptions related to COVID-19. The increase also reflects higher product costs. We believe the risk of supply chain disruptions has been reduced, and we are now lowering our inventory. During 2023, our goal is to reduce inventory by $5.0 million. The Company expects that changes in inventory levels will continue to be consistent with changes in sales, including the seasonal impact on the Company’s revenue stream. Inventory turnover calculated using a twelve-month average inventory balance, was 2.0 at December 31, 2022 as compared to 2.3 at December 31, 2021. The reserve for slow moving and obsolete inventory was $1,720,350 at December 31, 2022 compared to $1,554,217 at December 31, 2021. We do not anticipate material increases in the allowance for slow moving and obsolete inventory in the ordinary course of business during 2023. Receivables decreased by approximately $1.6 million at December 31, 2022 compared to December 31, 2021. The average number of days sales outstanding in accounts receivable was 62 days in 2022 compared to 60 days in 2021. Long-term debt consists of (i) borrowings under the Company’s revolving loan agreement with HSBC Bank, N.A. and (ii) amounts outstanding under the fixed rate mortgage related to the Company’s manufacturing and distribution facilities in Rocky Mount, NC and Vancouver, WA. On May 31, 2022, the Company amended its revolving loan agreement with HSBC Bank, N.A. The amendment increases the amount available for borrowing to $65 million from $50 million, at an interest rate of SOFR plus 1.75%; interest is payable monthly. In addition, the expiration date of the revolving loan agreement was extended to May 31, 2026. The Company must pay a facility fee, payable quarterly, in an amount equal to one eighth of one percent (.125%) per annum of the average daily unused portion of the revolving credit line. The facility is intended to provide liquidity for growth, share repurchases, dividends, acquisitions, and other business activities. Under the revolving loan agreement, the Company is required to maintain specific amounts of funded debt to EBITDA, a fixed charge coverage ratio and must have annual net income greater than $0, measured as of the end of each fiscal year. On November 8, 2022, the revolving loan agreement was amended to increase the ratio of funded debt to EBITDA. The amendment is in effect for four quarters commencing in the third quarter of 2022 and includes an increase in the funded debt to EBITDA ratio for the four quarters ranging from a low of 4.75 to 1 to a high of 5.75 to 1. The amendment also increases the interest rate from SOFR +1.75% up to a high of SOFR + 2.35% on a basis that varies on a quarterly basis with the funded debt to EBITDA ratio. The increase in the ratio brought the Company into compliance with the covenant as of September 30, 2022, and going forward, provides the Company with flexibility to conduct its business in light of current and anticipated economic conditions. As of December 31, 2022, the Company was in compliance with the covenants under the revolving loan agreement, as amended. At December 31, 2022, total debt outstanding under the Company’s revolving credit facility increased by approximately $16.9 million compared to total debt outstanding at December 31, 2021. As of December 31, 2022, $50,000,000 was outstanding and $15,000,000 was available for borrowing under the Company’s revolving credit facility. On May 7, 2020, the Company received a two-year loan (the “PPP Loan”) from HSBC Bank USA, N.A., the lender, in the amount of $3,508,047 under the Paycheck Protection Program established by the Coronavirus Aid, Relief and Economic Security Act (CARES Act). Under the CARES Act, all or a portion of the PPP Loan was eligible to be forgiven by the U.S. Small Business Administration (“SBA”) and the lender, upon application by the Company, provided that the Company shall have used the loan proceeds for certain eligible purposes. The PPP Loan was fully forgiven by the SBA and on June 9, 2021, payment in the amount of $3,508,047 was made by the SBA to the lender. The Company recorded the amount forgiven as income during the year ended December 31, 2021. The Company’s manufacturing and distribution facilities in Rocky Mount, NC and Vancouver, WA were financed by a fixed rate mortgage with HSBC Bank, N.A. at a fixed interest rate of 3.8%. The Company entered into the agreement on December 1, 2021. Payments of principal and interest are due monthly, with all amounts outstanding due on maturity on December 1, 2031. The outstanding principal on December 31, 2022, was $11,232,990. Capital expenditures during 2022 and 2021 were $4,304,264 and $6,372,615, respectively, which were, in part, financed with borrowings under the Company’s revolving credit facility. The decrease is primarily related to 2021 improvements at our distribution center in Rocky Mount, NC including new HVAC (approximately $2 million) and warehouse management systems (approximately $1 million). On June 1, 2022, the Company purchased the assets of Live Safely Products, LLC (d/b/a “Safety Made”) for approximately $11 million, including $1.5 million of which is contingent upon meeting certain annual financial targets during a two-year period. Based in Keene, NH, Safety Made is a leading manufacturer of first aid kits for the promotional products industry. 19 In response to the challenges encountered by the Company commencing with the COVID-19 pandemic, the Company has implemented a series of cost reduction initiatives that are expected to generate over $5.0 million in savings in 2023. These initiatives have included the implementation of a wide range of productivity improvements in our manufacturing and distribution facilities and a reduction of SG&A expenses and other costs. The Company believes that cash on hand, and cash generated from operating activities, together with funds available under its revolving credit facility, are expected, under current conditions, to be sufficient to finance the Company’s planned operations for at least the next twelve months from the issuance of this Form 10-K. Recently Issued and Adopted Accounting Standards Management does not believe that any recently issued, but not yet effective accounting standards, if currently adopted, would have a material effect on the Company’s consolidated financial statements. Item 7A. Quantitative and Qualitative Disclosures about Market Risk As a smaller reporting company, the Company is not required to provide this information.