CPS TECHNOLOGIES CORP/DE/ 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This document contains forward-looking statements, based on numerous assumptions, subject to risks and uncertainties. Although we believe that the forward-looking statements are reasonable, we do not and cannot give any assurance that our beliefs and expectations will prove to be correct. Many factors could significantly affect our operations and cause our actual results to be substantially different from our expectations. Those factors include, but are not limited to: (i) general economic and business conditions; (ii) customer acceptance of our products; (iii) materials and manufacturing costs; (iv) the financial condition of customers, competitors and suppliers; (v) technological developments; (vi) increased competition; (vii) changes in capital market conditions; (viii) governmental and business conditions in countries where our products are manufactured and sold; (ix) changes in trade regulations; (x) the effect of acquisition activity; (xi) changes in our plans, strategies, objectives, expectations or intentions; and (xii) other risks and uncertainties indicated from time to time in our filings with the Securities and Exchange Commission. Actual results might differ materially from results suggested by any forward-looking statements in this report. We do not have an obligation to publicly update any forward-looking statements, whether as a result of the receipt of new information, the occurrence of future events or otherwise. Overview The Company’s products contribute to the electrification of the green economy. The products we provide include baseplates for motor controllers used in high-speed electric trains, subway cars, wind turbines, and hybrid and electric vehicles. We provide baseplates and housings used in radar, satellite and avionics applications. We provide lids and heatspreaders used with high performance integrated circuits for in internet switches and routers. We provide baseplates and housings used in modules built with Wide Band Gap Semiconductors like SiC and GaN. CPS also assembles housings and packages for hybrid circuits. These housings and packages may include MMC components; they may include components made of more traditional materials such as aluminum, copper-tungsten, etc. CPS’s products are custom rather than catalog items. They are made to customers’ designs and are used as components in systems built and sold by our customers. At any point in time our product mix will consist of some products with on-going production demand, and some products which are in the prototyping or evaluation stages at our customers. The Company seeks to have a portfolio of products which include products in every stage of the technology adoption lifecycle at our customers. CPS’ growth is dependent upon the level of demand for those products already in production, as well as its success in achieving new "design wins" for future products. As a manufacturer of highly technical and custom products, the Company incurs fixed costs needed to support the business, but which do not vary significantly with changes in sales volume. These costs include the fixed costs of applications engineering, tooling design and fabrication, process engineering, etc. Accordingly, particularly given our current size, changes in sales volume generally result in even greater changes in financial performance on a percentage basis as fixed costs are spread over a larger or smaller base. Sales volume is therefore a key financial metric used by management. The Company believes the underlying demand for metal matrix composites is growing as the electronics and other industries seek higher performance, higher reliability, and reduced costs. CPS believes that the Company is well positioned to offer our solutions to current and new customers as these demands grow. In 2020 the Company’s top three customers accounted for 73% of revenue and the remaining 27% of revenue was derived from 61 other customers. In 2019 the top three customers accounted for 70% of revenue and the remaining 30% of revenue was derived from approximately 60 customers. COVID-19 Pandemic As a provider of essential services products and services, CPS has been open and operating throughout the novel coronavirus pandemic. To date most of our customers remain open and operational. In the second half of 2020 we saw significant increased volatility on the part of some of our customers, while for others it has been business as usual. We expect that this volatility will continue for at least the next several quarters. Unexpected significant reductions in demand by our largest customer led to a reduction in third and fourth quarter revenue. As these reductions were originally unexpected, by both CPS and our customer, inventory at various stages of production was built to meet expected demand, remains in inventory. This inventory was somewhat reduced in Q4, but will likely continue to remain somewhat inflated over the next quarter or two until it reaches equilibrium with current demand. CPS continues to follow CDC and OSHA guidance in our workplace. Employees’ temperatures are taken at the beginning of each shift, shifts have been staggered to reduce employee overlap, workstations have been rearranged to ensure social distancing, all employees are using facemasks, etc. The pandemic has had very little impact on our ability to produce and ship customer orders. Application of Critical Accounting Policies Financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. As such, the Company is required to make certain estimates, judgments and assumptions that it believes are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. CPS’s significant accounting policies are presented within Note 2 to the financial statements; the significant accounting policies which management believes are most critical to aid in fully understanding and evaluating its reported financial results include the following: a) Allowance for doubtful accounts The Company performs ongoing monitoring of the status of its receivables based on the payment history and the credit worthiness of our customers, as determined by a review of their current credit information. Management continuously monitors collections and payments from customers and maintains a provision for estimated credit losses based upon historical experience and any specific customer collection issues that have been identified. While such credit losses have historically been low and within expectations, there is no guarantee that we will continue to experience the same credit loss rates as in the past. Although the Company’s major customers are large and have a favorable payment history, a significant change in the liquidity or financial position of one of them could have a material adverse impact on the collectability of accounts receivable and future operating results. To further mitigate the potential for credit losses the Company has acquired a credit insurance policy covering most of our sales to non-US accounts. b) Inventory valuation The Company has a build-to-order business model and manufactures product to ship against specific purchase orders; occasionally CPS manufactures product in advance of anticipated purchase orders to level load production or prepare for a ramp-up in demand. In addition, 100% of the Company’s products are custom, meaning they are produced to a customer’s design and generally cannot be used for any other purpose. Purchase orders generally have cancellation provisions which vary from customer to customer, but which can result occasionally in CPS producing product which the customer is not obligated to purchase. However, once a product has gone into production, most customer orders are recurring and order cancellations are rare. The Company’s general obsolescence policy is to write off obsolete inventory when there has been no activity on a particular part for a twelve month period and there are no pending customer orders. In some cases, customers place blanket purchase orders and request the Company to maintain inventory sufficient to respond quickly upon receiving a shipment request. The Company manufactures to specifications and the products typically have a life which extends over several years and does not deteriorate over time. Therefore, the risk of obsolescence due to the passage of time, per se, is minimal. However, in order to more efficiently schedule production or to meet agreements with customers to have inventory in the pipeline, the Company occasionally manufactures products in advance of purchase orders. In these instances, the Company bears the risk that it will be left with product manufactured to specification for which there are no customer purchase orders. The Company scrutinizes its inventory and, in the absence of pending orders or strong evidence of future sales, establishes an obsolescence reserve when there has been no activity on a particular part for a twelve month period. In determining inventory cost, the Company uses the first-in, first-out method and states inventory at the lower of cost or net realizable value. Virtually, all of the Company’s inventory is customer specific; as a result, if a customer’s order is cancelled, it is unlikely that CPS would be able to sell that inventory to another customer. Likewise, if the Company chooses to manufacture product in advance of anticipated purchase orders and those orders do not materialize, it is unlikely that it would be able to sell that inventory to another customer. The value of CPS’s work in process and finished goods is based on the assumption that specific customers will take delivery of specific items of inventory. The Company has not experienced losses to date as a result of customer cancellations and has not established a reserve for such cancellations. The Company typically buys ‘lots’ of components for its hermetic packaging products. Often all the components in a lot are not necessary to complete the order. Annually the company reviews this unused material and establishes an obsolescence reserve for the amount it does not expect to use over the next three years. c) Valuation of deferred tax assets Deferred tax assets and liabilities are based on the net tax effects of tax credits, operating loss carryforwards and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company considers many factors in assessing whether or not a valuation allowance for its Deferred Tax Asset is warranted and has concluded that it is more likely than not that a portion or all of the Deferred Tax Asset will not be used before they expire. As a result a valuation reserve has been established as of December 28, 2019 and December 26, 2020. At December 26, 2020 the Company’s Deferred Tax Asset and other temporary differences will require taxable income of approximately $15 million and reversals of existing temporary differences to fully utilize the Deferred Tax Asset, assuming a statutory corporate tax rate of 21%. Results of Operations (all $ in millions unless noted) Results of Operations for the year 2020 (“2020”) compared with the year 2019 (“2019”): Total revenue was $20.9 million in 2020, a 3% decrease compared with total revenue of $21.4 million in 2019. This decrease was due primarily to a decrease in the sales from our largest customer because of the impact of the Covid-19 pandemic on their business. Our second and third largest customers showed increased sales, but not enough to offset the reduction from the largest customer. Much of our largest customer’s sales go to railroad companies who experienced significant reductions in ridership due to the pandemic. Gross margin in 2020 totaled $4.2 million or 20% of sales. This compares with $2.5 million, or 12% of sales, generated during 2019. The improvement in margin was primarily due to price increases which were fully in effect throughout 2020. Selling, general and administrative (SG&A) expenses were $3.3 million during 2020, an increase of 3% compared with SG&A expenses of $3.1 million incurred during 2019. The primary reason for this increase was increased professional fees, including costs incurred during our search for a Chief Operating Officer. This search was concluded in 2020; our new Chief Operating Officer began work on January 4, 2021. The Company generated operating income of $0.9 million in 2020, compared with an operating loss of $0.6 in 2019. This improvement was due primarily to the price increases, as discussed above; secondarily to operating efficiencies. The net income in 2020 totaled $0.9 versus a net loss of $0.6 in 2019. Significant Fourth Quarter Activity in 2020: Revenues totaled $4.2 million in the fourth quarter of 2020 versus $5.4 million in the fourth quarter of 2019, a decrease of 24%. This decrease was due primarily to a decrease in the sales of baseplates with our two largest customers. Both of these customers were negatively affected in the fourth quarter by Covid-19, although one showed growth for the year, but was down in the fourth quarter. Gross margin decreased in the fourth quarter of 2020 compared with the fourth quarter of 2019 to $0.5 million from $1.0 million. This decrease was directly associated with the decrease in revenue. SG&A expenses totaled $0.8 million during the quarter, an increase of 29% compared to $0.6 million in the same quarter of 2019. The primary reason for this increase was increased professional fees, including costs incurred during our search for a Chief Operating Officer. Primarily as a result of the revenue decrease, the Company recorded an operating loss of $0.3 million in the fourth quarter of 2020 compared to a income of $0.4 million in the fourth quarter of 2019. The Company recorded a net loss of $0.2 million in the fourth quarter of 2020 compared to a net earnings of $0.4 million in the fourth quarter of 2019. The operating loss in the fourth quarter of 2020 was reduced due to the sales of equipment as a result of the closing of the Attleboro facility. Liquidity and Capital Resources (all $ in millions unless noted) The Company’s cash and cash equivalents at December 26, 2020 totaled $0.2 compared with cash and cash equivalents at December 28, 2019 of $0.1. The Company’s net cash (cash and equivalents offset by borrowings under its line of credit) increased to $0.2 at December 26, 2020 from negative $1.1 at December 28, 2019. The increase was primarily due to the Company’s profitability for the year. Accounts receivable at December 26, 2020 totaled $2.9 compared to $4.1 at December 28, 2019. Days Sales Outstanding (DSO) decreased to 62 days at the end of 2020 compared to 67 days at the end of Q4 2019. This change was due in large part to the fact that sales were more front-end loaded in the quarter in 2020 and, as a result, a higher percentage of sales were collected during the quarter. The accounts receivable balances at December 26, 2020, and December 28, 2019 were both net of an allowance for doubtful accounts of $10 thousand. Inventories increased to $3.7 at December 26, 2020 from $3.1 at December 28, 2019. The inventory turnover in the most recent four quarters ending was 4.5 times, down from 6.2 times averaged during the four quarters of 2019 (each based on a 5 point average). The majority of our inventory is for our two largest customers, both of whom significantly decreased their projected purchases in the fourth quarter of 2020. The Company had no inventory on consignment at any customers at the end of 2019 or 2020. At December 26, 2020 and December 28, 2019 inventory of, $1.6 and $1.2, respectively, was located at vendor locations pursuant to inventory agreements. The Company funded its operations from its profit in 2020. The Company expects it will continue to be able to fund its operations during 2021 from existing cash balances, the existing credit facility and profits. The Company continues to sell to a limited number of customers and the loss of any one of these customers or vendors could cause the Company to require additional external financing. Failure to generate sufficient revenues, raise additional capital or reduce certain discretionary spending could have a material adverse effect on the Company’s ability to achieve its business objectives. Contractual Obligations In September 2019, the Company entered into revolving line of credit (LOC) with Massachusetts Business Development Corporation (BDC) in the amount of $2.5 million. The agreement includes a demand note allowing the Lender to call the loan at any time. The Company may terminate the agreement without a termination fee after 3 years. The LOC is secured by the accounts receivable and other assets of the Company and has an interest rate of LIBOR plus 650 basis points. BDC requires that the total earnings before taxes for 2020 be at least $749 thousand, which was achieved. BDC also required a $201 thousand earnings before taxes for the fourth quarter of 2020. A blanket waiver of compliance was issued by BDC for this and any other 2020 activity. At December 26, 2020 the Company had $0 borrowings under this LOC and its borrowing base at the time would have permitted an additional $2.2 to have been borrowed. In March 2020, the company acquired a scanning acoustic microscope for a price of $208 thousand. The full amount was financed through a 5 year note payable with a financing company. The note is collateralized by the microscope and is being paid in monthly installments of $4 thousand, consisting of principal plus interest at a rate of 6.47% In July 2020 CPS placed into service a piece of manufacturing equipment which it financed with the machine’s vendor. The equipment cost of $40 thousand will be paid at the rate of $2 thousand per month over 2 years with an interest rate of 1.9%. As of December 26, 2020 the Company had $61 thousand of construction in progress and no outstanding commitments to purchase production equipment. During 2020 our leasing arrangements consisted of the Norton, MA and Attleboro, MA facility leases. The Norton facility lease expires in February 2021 and is a triple net lease wherein the Company is responsible for payment of all real estate taxes, operating costs and utilities. In January 2021 the company entered into an amendment to the lease, extending its term for five years to February 2026. The Company also has an option to buy the property and a first right of refusal during the term of the lease. Annual rental payments continue at $152 thousand. The Attleboro lease expired December 31, 2020 and has not been renewed. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements. Inflation Inflation had no material effect on the results of operations or financial condition during the last few years. There can be no assurance however, that inflation will not affect our operations or business in the future. Item 7A. Quantitative and Qualitative Disclosure about Market Risk Smaller reporting companies are not required to provide the information required by this item. Item 8. Financial Statements and Supplementary Data See Index to the Company’s Financial Statements and the accompanying notes which are filed as part of this Annual Report on Form 10-K. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None.