EASTERN CO 10-Q

ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion is intended to highlight significant changes in the financial position and results of operations of The Eastern Company (together with its consolidated subsidiaries, the “Company,” “we,” “us” or “our”) for the quarter and nine months ended October 2, 2021. The interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto for the fiscal year ended January 2, 2021 and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in the Company’s Annual Report on Form 10-K for the fiscal year ended January 2, 2021, which was filed with the Securities and Exchange Commission (the “SEC”) on March 16, 2021 (the “2020 Form 10-K”). The Company’s fiscal year is a 52-53-week fiscal year ending on the Saturday nearest to December 31. References to 2020 or the 2020 fiscal year mean the 53-week period ended on January 2, 2021 and references to 2021 or the 2021 fiscal year mean the 52-week period ending on January 1, 2022. In a 52-week fiscal year, each quarter is 13 weeks long. In a 53-week fiscal year, each of the first two fiscal quarters and the fourth quarter are 13 weeks long, and the third fiscal quarter is 14 weeks long. References to the third quarter of 2020, the third fiscal quarter of 2020 or the three months ended October 3, 2020 mean the period from June 28, 2020 to October 3, 2020. References to the third quarter of 2021, the third fiscal quarter of 2021 or the three months ended October 2, 2021 mean the 13-week period from July 4, 2021 to October 2, 2021. References to the nine months ended October 3, 2020 or the first nine months of fiscal 2020 mean the period from December 29, 2019 to October 3, 2020, and references to the nine months ended October 2, 2021 or the first nine months of fiscal 2021 mean the period from January 3, 2021 to October 2, 2021. Safe Harbor for Forward-Looking Statements Statements contained in this Quarterly Report on Form 10-Q that are not based on historical facts are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of forward-looking terminology such as “should,” “could,” “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue,” or similar terms or variations of those terms or the negative of those terms. There are many factors that affect the Company’s business and the results of its operations and that may cause the actual results of operations in future periods to differ materially from those currently expected or anticipated. These factors include, but are not limited to: effects of the COVID-19 pandemic, vaccination rates, the emergence of virus variants and the measures being taken to limit the spread and resurgence of COVID-19, including supply chain disruptions, delays in delivery of our products to our customers, impact on demand for our products, reductions in production levels, increased costs, including costs of raw materials, the impact on global economic conditions, the availability, terms and cost of financing, including borrowings under credit arrangements or agreements, and risks associated with employees working remotely or operating with reduced workforce; the scope and duration of the COVID-19 pandemic, including the extent of resurgences, the development of variants and how quickly and to what extent normal economic activity can resume; the timing of the distribution of COVID-19 vaccines and rates of vaccination; risks associated with doing business overseas, including fluctuations in exchange rates and the inability to repatriate foreign cash, the impact on cost structure and on economic conditions as a result of actual and threatened increases in trade tariffs and the impact of political, economic and social instability; restrictions on operating flexibility imposed by the agreement governing our credit facility; the inability to achieve the savings expected from global sourcing of materials; the impact of higher raw material and component costs, particularly steel, plastics, scrap iron, zinc, copper and electronic components; lower-cost competition; our ability to design, introduce and sell new products and related components; market acceptance of our products; the inability to attain expected benefits from acquisitions or the inability to effectively integrate such acquisitions and achieve expected synergies; domestic and international economic conditions, including the impact, length and degree of economic downturns on the customers and markets we serve and more specifically conditions in the automotive, construction, aerospace, energy, oil and gas, transportation, electronic, commercial laundry, mining and general industrial markets; costs and liabilities associated with environmental compliance; the impact of climate change or terrorist threats and the possible responses by the U.S. and foreign governments; failure to protect our intellectual property; cyberattacks; materially adverse or unanticipated legal judgments, fines, penalties or settlements; and other risks identified and discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 1A, Risk Factors, and Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of the 2020 Form 10-K and that may be identified from time to time in our quarterly reports on Form 10-Q, current reports on Form 8-K and other filings we make with the SEC. Although the Company believes it has an appropriate business strategy and the resources necessary for its operations, future revenue and margin trends cannot be reliably predicted and the Company may alter its business strategies to address changing conditions. Also, the Company makes estimates and assumptions that may materially affect reported amounts and disclosures. These relate to valuation allowances for accounts receivable and excess and obsolete inventories, accruals for pensions and other postretirement benefits (including forecasted future cost increases and returns on plan assets), provisions for depreciation (estimating useful lives), uncertain tax positions, and, on occasion, accruals for contingent losses. The Company undertakes no obligation to update, alter, or otherwise revise any forward-looking statements, whether written or oral, that may be made from time to time, whether as a result of new information, future events, or otherwise, except as required by law. - 19 - Table of Contents Overview COVID-19 Update The direct impact of the COVID-19 pandemic has been minimal at most of our operations through the third quarter of 2021. We continue to follow CDC guidelines, including the use of proper personal protection equipment, social distancing and sanitizing work areas. All of these measures allowed the majority of our facilities to operate at full capacity where possible barring supply chain issues, port congestion, and labor shortages. Many of the Company’s employees have received their first COVID-19 vaccination, and we will continue to encourage our workforce to continue to get vaccinated. We do not anticipate further significant interruption in our operations unless a resurgence of the COVID-19 pandemic occurs. A significant resurgence of the COVID-19 pandemic could cause further disruptions in our business and could adversely affect our financial condition, results of operations and cash flow. During 2020 and continuing into 2021 the Company implemented a broad range of policies and procedures to ensure that employees at all of our locations remain healthy. Steps that we have taken to reduce the risk of COVID-19 to our employees include, among others: protecting employee health by instructing employees to stay home if they exhibit symptoms of COVID-19; requiring employees to wear masks upon entry into the workplace; providing standard surgical masks, unless this conflicts with OSHA requirements; and educating employees on hand hygiene to help stop the spread. We maintain a clean work environment by frequently cleaning all touch points with products that meet EPA criteria for use against COVID-19; educating employees to clean their personal workspace at the beginning and the end of every shift; and providing hand sanitizer and disposable wipes. We have minimized in-person contact between employees and with visitors; required essential employees to work from home if they are able to do so effectively; developed and implemented practices for social distancing in our facilities; and reduced the number and size of in-person meetings. We have eliminated all non-essential workplace travel, discouraged carpooling, and where we have multiple shifts, staggered shift start and stop times, break times, and lunchtimes to minimize congregations at the time clocks or break areas. Where possible, we have closed or restricted break rooms and cafeterias or used extra rotations to reduce the number of employees in the break rooms or cafeterias at one time to achieve social distancing norms. We continue to seek and implement additional methods to further reduce the risk of COVID-19 to our employees. Although we sustained delays and disruptions in 2020 to our supply chain and operations, the majority of our facilities have returned to normal operations however, one facility experienced an outbreak of COVID-19 among several employees resulting in closure of the factory for a few days at the end of June 2021. Currently, we do not anticipate further interruption of our operations unless a resurgence of the COVID-19 pandemic (including variants) occurs, which could cause further disruptions in our business and could adversely affect our financial condition, results of operations and cash flow. The future extent of the effect of the COVID-19 pandemic on our operational and financial performance will depend in large part on the emergence of virus variants, vaccination rates, continued mask wearing, social distancing and other developments, that cannot be predicted with confidence at this time. With the inherent uncertainty of the COVID-19 pandemic it is difficult to predict with any confidence the likely impact of the COVID-19 pandemic on our future operations and the extent it could have on our consolidated business, results of operations and financial condition. For a discussion of certain COVID-19-related risks, see Part I, Item 1A, “Risk Factors”, of the 2020 Form 10-K. General Overview We have determined that the companies included in our Diversified Products segment no longer fit with our long-term strategy, and we have initiated the process of divesting the companies within the Diversified Products segment. Selling the companies within this segment will allow management to focus on our core capabilities and offerings. The Diversified Products segment meets the criteria to be held for sale and, furthermore, we determined that the assets held for sale qualify as discontinued operations. As such, the financial results of the Diversified Products segment are reflected in our unaudited condensed consolidated statements of operations as discontinued operations for all periods presented. Additionally, current and non-current assets and liabilities of discontinued operations are reflected in the unaudited condensed consolidated balance sheets for both periods presented. The loss recognized in the write-down of the Diversified Products segment to fair value in the second quarter of 2021 was $8.1 million, net of tax. In the third quarter of 2021 a gain of $1.0 million, net of tax was recognized to adjust the Diversified Products segment to fair value. Anticipated cash flow over the next twelve months is approximately $25.0 million. The majority of this cash is expected to be used to pay down debt. - 20 - Table of Contents On November 3, 2021 the Company sold its Greenwald Industries, Inc. division (“Greenwald”) for a sales price of $8.0 million, subject to a final working capital adjustment. Greenwald, which is located in Chester, CT, is an OEM manufacturer offering a range of payment solutions from coin-vending products to smart card systems and payment applications. The following analysis excludes discontinued operations. Net sales in the third quarter of 2021 increased 15% to $63.9 million from $55.7 million in the corresponding period in 2020 and net sales for the first nine months of 2021 increased 27% to $186.9 million from $147.1 million in the same period last year. Sales increased for both the third quarter and nine-month periods due to increased demand for truck accessories, automotive returnable packaging, blow mold tooling, and distribution products. Backlog as of October 2, 2021 was up 44% to $83.1 million from $57.7 million as of October 3, 2020. Net sales of existing products increased 4% in the third quarter of 2021 and 18% for the first nine months of 2021 compared to the corresponding periods in 2020. Price increases and new products increased net sales by 10% in the third quarter of 2021 and 10% for the first nine months of 2021, compared to the corresponding periods in 2020. New products included various truck mirror assemblies, rotary latches, D-rings, and mirror cams. Cost of products sold increased $6.3 million, or 15%, in the third quarter of 2021 and increased $31.8 million, or 29% for the first nine months of 2021 compared to the corresponding periods in 2020. The increases are primarily due to higher sales volume, increases in the prices of material, and increases in freight rates. The prices of several frequently used raw materials prices have increased significantly, year-over-year. For example, the price of most common forms of hot-rolled steel increased 245% between the third quarter of 2020 and the third quarter of 2021; cold-rolled steel increased 206%; nickel increased 35%; scrap iron increased 85%; and copper and zinc increased 43% and 29% respectively. Additionally, our freight costs increased $1.4 million, or 110%, in the third quarter of 2021 and increased $3.5 million, or 99%, in the first nine months of 2021 when compared to the corresponding periods in 2020. This increase is due to increased sales volume and freight rates as shipping demand has exceeded available carriers. Price increases to our customers recovered a portion of the increase in raw material prices and freight rates. Finally, the Company paid tariff costs on China-sourced products of approximately $0.6 million and $2.0 million in the third quarter and first nine months of 2021 respectively, compared to $0.6 million and $2.4 million in the third quarter and first nine months of fiscal 2020 respectively. All tariffs on China-sourced products have been recovered through price increases. Gross margin as a percent of sales was 24% in the third quarter and 24% in the first nine months of fiscal 2021 compared to 24% in the third quarter and 25% in the first nine months of fiscal 2020. Product development expense increased $0.4 million, or 73% in the third quarter of 2021 and increased $0.7 million, or 28%, in the first nine months of 2021 compared to the corresponding periods in 2020. As a percentage of net sales, product development costs were 1.5% and 1.6% for the third quarter and first nine months of 2021, respectively, and 1.0%, and 1.6% for the corresponding periods in 2020, respectively. Selling and administrative expense increased $0.9 million, or 11%, in the third quarter of 2021 and increased $4.5 million, or 19% in the first nine months of 2021 compared to the corresponding period in 2020 primarily due to increased commissions and other selling costs, amortization expense, payroll-related expenses, and incentive costs, which were suspended in the first quarter of fiscal 2020. Interest expense decreased $0.1 million in the third quarter and decreased $0.2 million for the first nine months of 2021 compared to the corresponding periods in 2020. Other income was flat in the third quarter and increased $2.4 million in the first nine months of 2021 compared to the corresponding periods in 2020. The increase in other income of $2.4 million in the first nine months was driven by a gain on the sale of the Eberhard Hardware Ltd. Building of $1.8 million and a favorable return on pension plan assets of $0.6 million. Net income from continuing operations for the third quarter of fiscal 2021 was $3.8 million, or $0.61 per diluted share compared to net income of $3.2 million, or $0.51 per diluted share for the comparable period in 2020. In the first nine months of 2021 net income from continuing operations was $12.3 million, or $1.96 per diluted share compared to net income of $7.9 million, or $1.26 per diluted share for the comparable period in 2020. - 21 - Table of Contents A more detailed analysis of the Company’s results of operations and financial condition follows: Results of Operations The following table shows, for the periods indicated, selected line items from the condensed consolidated statements of operations as a percentage of net sales: Three Months Ended Nine Months Ended October 2, 2021 October 3, 2020 October 2, 2021 October 3, 2020 Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of products sold 76.2 % 76.0 % 76.1 % 75.1 % Gross margin 23.8 % 24.0 % 23.9 % 24.9 % Product development expense 1.5 % 1.0 % 1.6 % 1.6 % Selling and administrative expense 14.8 % 15.3 % 14.9 % 15.9 % Operating Profit 7.5 % 7.7 % 7.4 % 7.4 % The following table shows the change in sales and operating profit for the third quarter and first nine months of fiscal 2021 compared to the third quarter and first nine months of fiscal 2020 (dollars in thousands): Three Months Nine Months Ended Ended October 2, 2021 October 2, 2021 Net Sales $ 8,171 $ 39,838 Volume 4.3 % 17.5 % Price 2.4 % 1.6 % New products 8.0 % 8.0 % 14.7 % 27.1 % Operating Profit $ 515 $ 2,925 Liquidity and Sources of Capital The Company consumed approximately $3.3 million of cash from continuing operations during the first nine months of fiscal 2021 compared to generating approximately $19.4 million during the first nine months of fiscal 2020. The cash flows in the first nine months of fiscal 2021 were lower when compared to the corresponding period last year due to an increase in inventory and accounts receivable partially offset by an increase in accounts payable. The effects of the COVID-19 pandemic are continuing to impact the supply chain and as such inventories and accounts payable have increased due to increased shipping time and port congestion as well as selective pre-buying of raw materials to avoid increasing prices. Cash flow from operations coupled with cash at the beginning of the 2021 fiscal year was sufficient to fund capital expenditures, debt service, and dividend payments for the first nine months of fiscal 2021. Additions to property, plant and equipment were approximately $2.1 million for the first nine months of fiscal 2021 and $1.5 million for the first nine months of fiscal 2020 from continuing operations. Additionally, in the first nine months of 2021 the company received proceeds of $2.0 million from the sale of one of its facilities in Canada. As of October 2, 2021, there were approximately $0.3 million of outstanding commitments for capital expenditures. - 22 - Table of Contents The following table shows key financial ratios at the end of each specified period: Third Quarter 2021 Third Quarter 2020 Fiscal Year 2020 Current ratio 2.7 3.2 2.8 Average days’ sales in accounts receivable 61 53 56 Inventory turnover 3.3 3.8 3.6 Total debt to shareholders’ equity 75.0 % 89.5 % 85.0 % The following table shows important liquidity measures as of the balance sheet date for each specified period (in millions): Third Third Fiscal Quarter Quarter Year 2021 2020 2020 Cash and cash equivalents - Held in the United States $ 7.0 $ 13.9 $ 10.0 - Held by a foreign subsidiary 3.0 5.7 6.1 10.0 19.6 16.1 Working capital 95.0 74.5 71.1 Net cash (used in) provided by operating activities (3.3 ) 16.7 20.7 Change in working capital impact on net cash (used in) provided by operating activities (17.4 ) 3.2 2.0 Net cash provided by (used in) investing activities 0.6 7.3 (9.1 ) Net cash used in financing activities (6.4 ) (7.5 ) (13.2 ) Inventories of $56.7 million as of October 2, 2021 represent an increase of 31.5% as compared to $43.1 million at the end of fiscal year 2020 and an increase of 46.1% as compared to $38.8 million at the end of the third quarter of fiscal 2020. Accounts receivable, less allowances, were $41.3 million as of October 2, 2021, as compared to $31.8 million at 2020 fiscal year end and $28.0 million at the end of the third quarter of fiscal 2020. Cash, cash flow from operating activities and funds available under the revolving credit portion of the Credit Agreement are expected to be sufficient to cover future foreseeable working capital requirements. However, based on current macroeconomic conditions resulting from the uncertainty caused by COVID-19, the Company cannot provide any assurances of the availability of future financing or the terms on which it might be available. In addition, the interest rate on borrowings under the Credit Agreement varies based on our senior net leverage ratio, and the Credit Agreement requires us to maintain a senior net leverage ratio not to exceed 4.25 to 1 and a fixed charge coverage ratio to be not less than 1.25 to 1. A decrease in earnings due to the impact of COVID-19 or the resulting harm to the financial condition of our customers or economic conditions generally, or an increase in indebtedness incurred to offset such a decrease in earnings, would have a negative impact on our senior net leverage ratio and our fixed charge coverage ratio, which in turn would increase the cost of borrowing under the Credit Agreement and could cause us to fail to comply with the covenants under our Credit Agreement. Off-Balance Sheet Arrangements As of the end of the fiscal quarter ended October 2, 2021, the Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Non-GAAP Financial Measures The non-GAAP financial measures we provide in this report should be viewed in addition to, and not as an alternative for, results prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). - 23 - Table of Contents To supplement the consolidated financial statements prepared in accordance with U.S. GAAP, we have presented Adjusted Net Income from Continuing Operations, Adjusted Earnings Per Share from Continuing Operations and Adjusted EBITDA from Continuing Operations, which are considered non-GAAP financial measures. The non-GAAP financial measures presented may differ from similarly titled non-GAAP financial measures presented by other companies, and other companies may not define these non-GAAP financial measures in the same way. These measures are not substitutes for their comparable U.S. GAAP financial measures, such as net sales, net income, diluted earnings per common share, or other measures prescribed by U.S. GAAP, and there are limitations to using non-GAAP financial measures. Adjusted Net Income from Continuing Operations is defined as net income from continuing operations excluding, when they occur, the impacts of impairment losses, losses on sale of subsidiaries, transaction expenses, factory start-up costs, factory relocation expenses and restructuring costs. Adjusted Net Income from Continuing Operations is a tool that can assist management and investors in comparing our performance on a consistent basis by removing the impact of certain items that management believes do not directly reflect our underlying operations. Adjusted Earnings Per Share from Continuing Operations is defined as diluted earnings per share from continuing operations excluding, when they occur, the impacts of impairment losses, losses on sale of subsidiaries, transaction expenses, gain on sale of building, factory start-up costs, factory relocation expenses and restructuring costs. We believe that Adjusted Earnings Per Share from Continuing Operations provides important comparability of underlying operational results, allowing investors and management to access operating performance on a consistent basis. Adjusted EBITDA from Continuing Operations is defined as net income from continuing operations before interest expense, provision for income taxes, and depreciation and amortization and excluding, when they occur, the impacts of impairment losses, losses on sale of subsidiaries, transaction expenses, gain on sale of building, factory start-up costs, factory relocation expenses and restructuring expenses. Adjusted EBITDA from Continuing Operations is a tool that can assist management and investors in comparing our performance on a consistent basis by removing the impact of certain items that management believes do not directly reflect our underlying operations. Management uses such measures to evaluate performance period over period, to analyze the underlying trends in our business including our business segments, to assess our performance relative to our competitors, and to establish operational goals and forecasts that are used in allocating resources. These financial measures should not be considered in isolation from, or as a replacement for, U.S. GAAP financial measures. We believe that presenting non-GAAP financial measures in addition to U.S. GAAP financial measures provides investors greater transparency to the information used by our management for its financial and operational decision-making. We further believe that providing this information better enables our investors to understand our operating performance and to evaluate the methodology used by management to evaluate and measure such performance. - 24 - Table of Contents Reconciliation of Non-GAAP Measures EPS from Continuing Operations Calculation For the Three and Nine Months ended October 2, 2021 and October 3, 2020 ($000's) Three Months Ended Nine Months Ended October 2, 2021 October 3, 2020 October 2, 2021 October 3, 2020 Net income from continuing operations as reported per generally accepted accounting principles (GAAP) $ 3,820 $ 3,156 $ 12,269 $ 7,879 Earnings per share from continuing operations as reported under generally accepted accounting principles (GAAP): Basic $ 0.61 $ 0.51 $ 1.96 $ 1.26 Diluted $ 0.61 $ 0.51 $ 1.96 $ 1.26 Adjustments: Gain on sale of Eberhard Hardware Ltd building, net of tax - - (1,353 ) A - Factory relocation, net of tax 45 E 188 B 105 E 188 B Transaction expenses 184 C 204 C Factory start-up costs, net of tax 155 D 187 D Total adjustments (Non-GAAP) $ 200 $ 372 $ (1,061 ) $ 392 Adjusted net income from continuing operations $ 4,020 $ 3,528 $ 11,208 $ 8,271 Adjusted earnings per share from continuing operations (Non-GAAP): Basic $ 0.64 $ 0.57 $ 1.79 $ 1.33 Diluted $ 0.64 $ 0.57 $ 1.79 $ 1.33 A) Gain on sale of Eberhard Hardware Ltd building B) Cost incurred on relocation of Velvac factory in Reynosa, MX C) Costs incurred on the acquisition of Hallink RSB, Inc. D) Costs incurred on start-up of Eberhard factory in Reynosa, MX E) Costs incurred on relocation of ILC facility in Wheeling, IL - 25 - Table of Contents Reconciliation of Non-GAAP Measures EBITDA from Continuing Operations Calculation For the Three and Nine Months ended October 2, 2021 and October 3, 2020 ($000's) Three Months Ended Nine Months Ended October 2, 2021 October 3, 2020 October 2, 2021 October 3, 2020 Net income from continuing operations as reported per generally accepted accounting principles (GAAP) $ 3,820 $ 3,156 $ 12,269 $ 7,879 Interest expense 427 485 1,389 1,561 Provision for income taxes 972 1,022 3,573 2,477 Depreciation and amortization 1,658 1,754 5,189 4,967 Gain on sale of Eberhard Hardware Ltd Building - - (1,841 ) A - Factory relocation 59 E 251 B 139 E 251 B Transaction expenses - 184 C - 204 C Factory start-up costs 207 D 250 D Adjusted EBITDA from continuing operations $ 7,143 $ 6,852 $ 20,968 $ 17,339 A) Gain on sale of Eberhard Hardware Ltd building B) Cost incurred on relocation of Velvac factory in Reynosa, MX C) Costs incurred on the acquisition of Hallink RSB, Inc. D) Costs incurred on start-up of Eberhard factory in Reynosa, MX E) Costs incurred on relocation of ILC facility in Wheeling, IL - 26 - Table of Contents ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As a result of the Company’s status as a smaller reporting company pursuant to Rule 12b-2 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the Company is not required to provide information under this Item 3.