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 1, 2022. 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 1, 2022 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 1, 2022, which was filed with the Securities and Exchange Commission (the “SEC”) on March 17, 2022 (the “2021 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 2021 or the 2021 fiscal year mean the 52-week period ended on January 1, 2022, and references to 2022 or the 2022 fiscal year mean the 52-week period ending on December 31, 2022. In a 52-week fiscal year, each quarter has 13 weeks. References to the third quarter of 2021, the third fiscal quarter of 2021 or the three months ended October 2, 2021 mean the period from July 4, 2021 to October 2, 2021. References to the third quarter of 2022, the third fiscal quarter of 2022 or the three months ended October 1, 2022, mean the 13-week period from July 3, 2022 to October 1, 2022. References to the first nine months of 2021 or the nine months ended October 2, 2021 mean the period from January 3, 2021 to October 2, 2021. References to the first nine months of 2022 or the nine months ended October 1, 2022 mean the period from January 2, 2022 to October 1, 2022. Safe Harbor for Forward-Looking Statements Statements contained in this Quarterly Report on Form 10-Q of the Company 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 “would,” “should,” “could,” “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue,” “plan,” “potential,” “opportunities,” 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 the scope and duration of the COVID-19 pandemic and economic effects of the COVID-19 pandemic, including supply chain disruptions, cost inflation, rising interest rates, 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, and the availability, terms and cost of financing, including borrowings under credit arrangements or agreements. Other factors include, but are not limited to 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, including the impact of supply chain shortages and inflation, 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, 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 2021 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. 17 Table of Contents Overview COVID-19 Update The COVID-19 pandemic has affected our businesses, including our supply chain, our operations, the labor force, costs and interest rates throughout 2021 and the first nine months of 2022. We continue to follow CDC guidelines, including the use of proper personal protection equipment, social distancing, and sanitizing work areas. As a result of these measures, the COVID pandemic had minimal impact on our North American capacity utilization at most of our production facilities in the third quarter of 2022. Many of the Company’s employees have received COVID-19 vaccinations, and we will continue to encourage our workforce to get vaccinated. In the second quarter of 2022, we experienced interruptions in China of our operations and supply base as a result of a new variant of COVID-19 and the response to minimize its spread. A more significant resurgence of the COVID-19 pandemic or development of additional severe or highly contagious variants could cause further disruptions in our business and could adversely affect our financial condition, results of operations and cash flow. During the past two years and continuing through the first nine months of 2022, the Company implemented a broad range of policies and procedures to ensure that employees at all 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; providing standard surgical masks 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 encourage social distancing, limit in-person meetings, reduced all non-essential workplace travel and continue to seek and implement additional methods to reduce the risk of COVID-19 to our employees. The extent to which our operations will be further affected by COVID-19 and its lasting economic impact, including supply chain disruptions, cost inflation and rising interest rates, in the fourth quarter of 2022 and fiscal year 2023 is dependent on future developments including new COVID variants, effectiveness of vaccines, new medication, and governmental restrictions. All these factors could result in further supply chain shortages and resulting cost inflation, increased operating cost, difficulty in finding workers, continued port congestion, and higher shipping costs. 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 of the effects 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 2021 Form 10-K. General Overview The following analysis excludes discontinued operations. Net sales in the third quarter of 2022 increased by 12% to $71.6 million from $63.9 million in the corresponding period in 2021. Net sales for the first nine months of 2022 increased 12% to $210.2 million from $186.9 million in the same period last year. Sales rose for both the third quarter and nine-month periods due to greater demand for truck accessories and returnable transport packaging products as well as from distributors. Our returnable transport packaging sales continue to benefit from the increase in new automotive product launches, including several electric vehicle launches. Our backlog as of October 1, 2022 increased 3% to $85.7 million from $83.1 million as of October 2, 2021. Net sales of existing products grew by 5% in the third quarter of 2022 and 6% for the first nine months of 2022 compared to the corresponding periods in 2021. Price increases and new products increased net sales by 7% in the third quarter and 6% in the first nine months of 2022, compared to the corresponding periods in 2021. New products included various truck mirror assemblies, rotary latches, D-rings, and mirror cams. Price increases primarily reflect our efforts to recover increases in raw material and freight costs. Cost of products sold increased by $6.4 million, or 13%, in the third quarter of 2022 and increased by $20.9 million, or 15% in the first nine months of 2022 compared to the corresponding periods in 2021. The increases are primarily due to higher sales volume and increases in the cost of materials. The cost of several frequently used raw materials have increased significantly, year-over-year. For example, the cost of nickel and zinc increased 30% and 17% respectively between the third quarter of 2021 and the third quarter of 2022. Price increases to our customers recovered a portion of the increase in raw material costs. Finally, the Company paid tariff costs on China-sourced products of approximately $0.8 million and $2.5 million in the third quarter and first nine months of 2022 respectively, compared to $0.6 million and $2.0 million in the third quarter and first nine months of 2021 respectively. A significant portion of tariffs on China-sourced products have been recovered through price increases. Gross margin as a percent of sales was 23% in the third quarter and 22% in the first nine months of 2022 compared to 24% in the third quarter and 24% in the first nine months of fiscal 2021. Our gross margins in the third quarter and first nine months of 2022 reflect the impact of price increases to customers to recover increases in raw material costs. Product development expense increased $0.1 million, or 5%, in the third quarter of 2022 and increased $0.1 million, or 3%, in the first nine months of 2022 compared to the corresponding periods in 2021. As a percentage of net sales, product development costs were 1.4% and 1.5% for the third quarter and first nine months of 2022, respectively, compared to 1.5% and 1.6% for the corresponding periods in 2021. 18 Table of Contents Selling, general and administrative expense increased $0.7 million, or 7%, in the third quarter of 2022 and increased $2.4 million, or 9% in the first nine months of 2022 when compared to the corresponding periods in 2021 primarily due to increased commissions and other selling costs, payroll-related expenses, and travel costs. This increase in selling expenses reflect both the increase in sales as well as our investments in sales capabilities. Interest expense increased $0.2 million in the third quarter of 2022 and $0.2 million in the first nine months of 2022 compared to the corresponding periods in 2021. Other income increased $0.7 million in the third quarter and decreased $1.2 million in the first nine months of 2022 compared to the corresponding periods in 2021. The increase in other income of $0.7 million in the third quarter of 2022 was primarily driven by a $0.6 million gain on the sale of the Eastern Company corporate office building. The $1.2 million decrease in other income for the first nine months of 2022 was primarily driven by a gain on the sale of the Eberhard Hardware Ltd. building of $1.8 million in the first quarter of 2021, partially offset by increased gains in pension cost adjustments in 2022. Net income from continuing operations for the third quarter of fiscal 2022 was $4.5 million, or $0.72 per diluted share compared to net income from continuing operations of $3.8 million, or $0.61 per diluted share, for the comparable period in 2021. In the first nine months of 2022 net income from continuing operations was $10.9 million, or $1.74 per diluted share, compared to net income from continuing operations of $12.3 million, or $1.96 per diluted share, for the comparable period in 2021. 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 1, 2022 October 2, 2021 October 1, 2022 October 2, 2021 Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of products sold 76.9 % 76.2 % 77.6 % 76.1 % Gross margin 23.1 % 23.8 % 22.4 % 23.9 % Product development expense 1.4 % 1.5 % 1.5 % 1.6 % Selling and administrative expense 14.1 % 14.8 % 14.3 % 14.9 % Operating Profit 7.6 % 7.5 % 6.6 % 7.4 % 19 Table of Contents The following table shows the change in sales and operating profit for the third quarter and first nine months of 2022 compared to the third quarter and first nine months of 2021 (dollars in thousands): Three Months Nine Months Ended Ended October 1, 2022 October 1, 2022 Net Sales $ 7,760 $ 23,294 Volume 5.0 % 5.9 % Price 5.3 % 3.5 % New products 1.8 % 3.0 % 12.1 % 12.4 % Operating Profit $ 635 $ (25 ) Liquidity and Sources of Capital The Company consumed approximately $0.3 million of cash from continuing operations during the first nine months of fiscal 2022 compared to consuming approximately $3.3 million during the first nine months of fiscal 2021. Cash flow from operations in the first nine months of 2022 was higher when compared to the corresponding period last year primarily due to a smaller increase in inventory and accounts receivable. The effects of the COVID-19 pandemic are continuing to impact the supply chain and as a result inventories have increased due to increased shipping time, port congestion, and selective pre-buying of raw materials to ensure availability and mitigate the impact of likely future inflationary price increases. Cash flow from operations coupled with cash at the beginning of the 2022 fiscal year and the proceeds from the line of credit were sufficient to fund capital expenditures, debt service, and dividend payments for the first nine months of 2022. The Company has $11.0 million available on its revolving line of credit as of October 1, 2022. On October 21, 2022 the Company used the proceeds from the sale of assets of Argo EMS to pay down an additional $5 million on the revolving line of credit. See Note G - Debt for further discussion on the Company’s debt facilities. Additions to property, plant and equipment for continuing operations were approximately $1.7 million for the first nine months of 2022 and $2.1 million for the first nine months of 2021. Additionally, in the first nine months of 2022 the Company received proceeds of $2.1 million from the sale of two of its properties compared to $2.0 million from the sale of one of its facilities in Canada during the first nine months of 2021. As of October 1, 2022, there were approximately $1.1 million of outstanding commitments for capital expenditures. The following table shows key financial ratios at the end of each specified period: Third Quarter 2022 Third Quarter 2021 Fiscal Year 2021 Current ratio 2.9 2.7 2.5 Average days’ sales in accounts receivable 67 61 64 Inventory turnover 3.2 3.3 3.0 Total debt to shareholders’ equity 60.3 % 75.0 % 62.2 % 20 Table of Contents The following table shows important liquidity measures as of the balance sheet date for each specified period or for the period, as applicable (in millions): Third Third Fiscal Quarter Quarter Year 2022 2021 2021 Cash and cash equivalents - Held in the United States $ 3.2 $ 7.0 $ 4.3 - Held by a foreign subsidiary 2.5 3.0 2.3 5.7 10.0 6.6 Working capital 90.6 95.0 74.1 Net cash (used in) provided by operating activities (0.3 ) (3.3 ) (7.8 ) Change in working capital impact on net cash used in operating activities (16.5 ) (17.4 ) (22.9 ) Net cash provided by investing activities 0.8 0.6 13.6 Net cash used in financing activities (0.5 ) (6.4 ) (20.3 ) Inventories of $67.5 million as of October 1, 2022, represent an increase of 7.4% as compared to $62.9 million at the end of fiscal year 2021 and an increase of 19.1% as compared to $56.7 million at the end of the third quarter of fiscal 2021. Accounts receivable, less allowances, were $50.9 million as of October 1, 2022, as compared to $43.2 million at 2021 fiscal year end and $41.3 million at the end of the third quarter of fiscal 2021. 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, 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. As of the end of the fiscal quarter ended October 1, 2022, 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. Critical Accounting Estimates The preparation of financial statements in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) requires management to make judgments, estimates and assumptions regarding uncertainties that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses. For a full description of our critical accounting policies, refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of the 2021 Form 10-K. While there have been no material changes to our critical accounting estimates, we continue to monitor the methodologies and assumptions underlying such critical accounting estimates. 21 Table of Contents 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 U.S. GAAP. 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 Diluted 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 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 incurred, certain one-time costs arising from the impacts of impairment losses, gains/losses on the sale of subsidiaries, property and facilities, transaction expenses primarily relating to acquisitions and divestitures, 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 operating performance. Adjusted Earnings Per Diluted Share from Continuing Operations is defined as earnings per diluted share from continuing operations excluding, when incurred, certain per share one-time costs arising from, for example, the impacts of impairment losses, gains/losses on the sale of subsidiaries, property and facilities, transaction expenses primarily relating to acquisitions and divestitures, factory start-up costs, factory relocation expenses and restructuring costs. We believe that Adjusted Earnings Per Diluted 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 incurred, the impacts of certain one-time costs arising from impairment losses, gains/losses on sale of subsidiaries, property and facilities, transaction expenses primarily relating to acquisitions and divestitures, 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, 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. 22 Table of Contents Reconciliation of Non-GAAP Measures Adjusted Net Income and EPS from Continuing Operations Calculation For the Three and Nine Months ended October 1, 2022 and October 2, 2021 ($000’s) Three Months Ended Nine Months Ended October 1, 2022 October 2, 2021 October 1, 2022 October 2, 2021 Net income from continuing operations as reported per generally accepted accounting principles (GAAP) $ 4,496 $ 3,820 $ 10,883 $ 12,269 Earnings per share from continuing operations as reported under generally accepted accounting principles (GAAP): Basic $ 0.72 $ 0.61 $ 1.75 $ 1.96 Diluted $ 0.72 $ 0.61 $ 1.74 $ 1.96 Adjustments: Gain on sale of Eberhard Hardware Ltd building, net of tax — — — (1,353 )A Factory relocation, net of tax — 45 B — 105 B Factory start-up costs, net of tax — 155 C — 187 C Loss on sale of Wheeling, IL building, net of tax — — 202 D — Gain on sale of Eastern corporate office building, net of tax (474 )E — (474 )E — Total adjustments (Non-GAAP) $ (474 ) $ 200 $ (272 ) $ (1,061 ) Adjusted net income from continuing operations $ 4,022 $ 4,020 $ 10,611 $ 11,208 Adjusted earnings per share from continuing operations (Non-GAAP): Basic $ 0.65 $ 0.64 $ 1.70 $ 1.79 Diluted $ 0.65 $ 0.64 $ 1.70 $ 1.79 A) Gain on sale of Eberhard Hardware Ltd building B) Costs incurred on relocation of ILC facility in Wheeling, IL C) Costs incurred on start-up of Eberhard factory in Reynosa, MX D) Loss on sale of ILC building in Wheeling, IL E) Gain on sale of Eastern corporate office building 23 Table of Contents Reconciliation of Non-GAAP Measures Adjusted EBITDA from Continuing Operations Calculation For the Three and Nine Months ended October 1, 2022 and October 2, 2021 ($000’s) Three Months Ended Nine Months Ended October 1, 2022 October 2, 2021 October 1, 2022 October 2, 2021 Net income from continuing operations as reported per generally accepted accounting principles (GAAP) $ 4,496 $ 3,820 $ 10,883 $ 12,269 Interest expense 646 427 1,584 1,389 Provision for income taxes 1,423 972 3,498 3,573 Depreciation and amortization 1,756 1,658 5,389 5,189 Gain on sale of Eberhard Hardware Ltd Building — — — (1,841 ) A Factory relocation — 59 B — 139 B Factory start-up costs — 207 C — 250 C Loss on sale of Wheeling, IL building — — 269 D — Gain on sale of Eastern corporate office building (624 )E — (624 )E — Adjusted EBITDA from continuing operations $ 7,697 $ 7,143 $ 20,999 $ 20,968 A) Gain on sale of Eberhard Hardware Ltd building B) Costs incurred on relocation of ILC facility in Wheeling, IL C) Costs incurred on start-up of Eberhard factory in Reynosa, MX D) Loss on sale of ILC building in Wheeling, IL E) Gain on sale of Eastern corporate office building 24 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.