Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements in this document constitute “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). All statements other than statements of historical fact included in this Annual Report, including statements regarding the Company’s future financial condition, results of operations, business operations and business prospects, are forward-looking statements. Words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “predict,” “believe” and similar words, expressions and variations of these words and expressions are intended to identify forward-looking statements. Such forward-looking statements are subject to known and unknown risks, uncertainties, assumptions, and other important factors that could significantly impact results or achievements expressed or implied by such forward-looking statements. Such factors, risks, uncertainties and assumptions include, but are not limited to, competitive and general economic conditions, both domestically and internationally; changes in customer demands; technological changes in our operations or in our industry; dependence on customers’ required delivery schedules; risks related to fluctuations in the Company’s operating results from quarter to quarter; risks related to international operations, including foreign currency fluctuations; changes in the legal and regulatory environment; changes in raw materials and commodity costs; the effects of COVID-19; and acts of terrorism, war, governmental action, natural disasters and other Force Majeure events. The cautionary statements made pursuant to the Reform Act herein and elsewhere by us should not be construed as exhaustive. We cannot always predict what factors would cause actual results to differ materially from those indicated by the forward-looking statements. Over time, our actual results, performance, or achievements will likely differ from the anticipated results, performance or achievements that are expressed or implied by our forward-looking statements, and such difference might be significant and harmful to our stockholders’ interest. Many important factors that could cause such a difference are described under the caption “Risk Factors,” in Item 1A of this Annual Report, which you should review carefully.
MANAGEMENT’S DISCUSSION AND ANALYSIS
INTRODUCTION
Kewaunee Scientific Corporation is a recognized leader in the design, manufacture and installation of laboratory, healthcare and technical furniture products. The Company’s corporate headquarters are located in Statesville, North Carolina. Direct sales offices are located in the United States, India, and Singapore. Three manufacturing facilities are located in Statesville serving the domestic and international markets, and one manufacturing facility is located in Bangalore, India serving the Indian, Middle East and Asian markets. Kewaunee Scientific Corporation’s website is located at www.kewaunee.com .
Our products are primarily sold through purchase orders and contracts submitted by customers through our dealers and commissioned agents, a national distributor, and through competitive bids submitted by us and our subsidiaries. Products are sold
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principally to pharmaceutical, biotechnology, industrial, chemical and commercial research laboratories, educational institutions, healthcare institutions, governmental entities, manufacturing facilities and users of networking furniture. We consider the markets in which we compete to be highly competitive, with a significant amount of the business involving competitive public bidding.
It is common in the laboratory and healthcare furniture industries for customer orders to require delivery at extended future dates, as products are frequently to be installed in buildings yet to be constructed. Changes or delays in building construction may cause delays in delivery of the orders and our recognition of the sale. Since prices are normally quoted on a firm basis in the industry, we bear the burden of possible increases in labor and material costs between quotation of an order and delivery of the product. The impact of such possible increases is considered when determining the sales price. The principal raw materials and products manufactured by others used in our products are cold-rolled carbon and stainless steel, hardwood lumbers and plywood, paint, chemicals, resins, hardware, plumbing and electrical fittings. Such materials and products are purchased from multiple suppliers and are typically readily available.
CRITICAL ACCOUNTING POLICIES
In the ordinary course of business, we have made estimates and assumptions relating to the reporting of results of operations and financial position in the preparation of our consolidated financial statements in conformity with generally accepted accounting principles in the United States of America. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations, and require management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
Revenue Recognition
The Company recognizes revenue when control of a good or service promised in a contract (i.e., performance obligation) is transferred to a customer. Control is obtained when a customer has the ability to direct the use of and obtain substantially all of the remaining benefits from that good or service. The majority of the Company’s revenues are recognized over time as the customer receives control as the Company performs work under a contract. However, a portion of the Company’s revenues are recognized at a point-in-time as control is transferred at a distinct point in time per the terms of a contract.
Allowance for Doubtful Accounts
Evaluation of the allowance for doubtful accounts involves management judgments and estimates. We evaluate the collectability of our trade accounts receivable based on a number of factors. In circumstances where management is aware of a customer’s inability to meet its financial obligations to us, or a project dispute makes it unlikely that all of the receivable owed by a customer will be collected, a specific reserve for bad debts is estimated and recorded to reduce the recognized receivable to the estimated amount we believe will ultimately be collected. In addition to specific customer identification of potential bad debts, a general reserve for bad debts is estimated and recorded based on our recent past loss history and an overall assessment of past due trade accounts receivable amounts outstanding.
Inventories
The Company’s inventories are valued at the lower of cost or net realizable value using the first-in, first-out (“FIFO”) method.
Pension Benefits
We sponsor pension plans covering all employees who met eligibility requirements as of April 30, 2005. These pension plans were amended as of April 30, 2005, no further benefits have been, or will be, earned under the plans subsequent to the amendment date, and no additional participants have been, or will be, added to the plans. Several statistical and other factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the pension plans. These factors include assumptions about the discount rate used to calculate and determine benefit obligations and the expected return on plan assets within certain guidelines. The actuarial assumptions used by us may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates, or longer or shorter life spans of participants. These differences may significantly affect the amount of pension income or expense recorded by us in future periods.
Self-Insurance Reserves
The Company’s domestic operations are self-insured for employee health care. The Company has purchased specific stop-loss insurance to limit claims above a certain amount. Estimated medical costs were accrued for claims incurred but not reported using assumptions based upon historical loss experiences. The Company’s exposure reflected in the self-insurance reserves varies depending upon market conditions in the insurance industry, availability of cost-effective insurance coverage, and actual claims versus estimated future claims.
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RESULTS OF OPERATIONS
Sales for fiscal year 2020 were $147.5 million, an increase of 0.7% from fiscal year 2019 sales of $146.6 million. Domestic sales for fiscal year 2020 were $115.1 million, a decrease of 1.3% compared to fiscal year 2019 sales of $116.6 million. International sales for fiscal year 2020 were $32.4 million, an increase of 8.3% from fiscal year 2019 sales of $30.0 million. The increase in International sales for fiscal year 2020 is the result of continued deliveries of a large order in the Middle East market.
Our order backlog was $100.9 million at April 30, 2020, as compared to $100.8 million at April 30, 2019.
Gross profit represented 15.9% and 17.3% of sales in fiscal years 2020 and 2019, respectively. The decrease in gross profit margin percentage was a result of a number of low margin orders that the Company aggressively pursued and secured over the past year, which included a strategic Middle East order aggressively secured over two years ago at lower than normal margins which was delivered in the current fiscal year. Additionally, profitability was impacted during the year as a result of the coronavirus pandemic.
Operating expenses were $25.8 million and $23.2 million in fiscal years 2020 and 2019, respectively, and 17.5% and 15.8% of sales, respectively. The increase in operating expense dollars in fiscal year 2020 as compared to fiscal year 2019 is related primarily to an increase in personnel expenses of $798,000, incentive and stock compensation of $385,000, restructuring expenses of $312,000, and depreciation expense of $136,000. The increased personnel expenses were driven by investments in talent to accelerate our strategy to modernize our manufacturing capabilities and information technology platform. Also contributing to the increase was an increase of bad debt expense of $299,000 related primarily to the closure of our China subsidiary, other China closure expenses of $48,000, $134,000 of expenses related to our new Indian subsidiary, and increases of $510,000 in other International subsidiary operating expenses, partially offset by decreases in management separation expenses of $388,000 and professional and consulting fees of $308,000. See Note 11 of the Notes to the Consolidated Financial Statements included in Item 8 for additional information concerning the Company's restructuring costs.
Other income (expense) was $426,000 and $684,000 in fiscal years 2020 and 2019, respectively. The decrease in other income (expense) in fiscal year 2020 was primarily due to the decrease in interest income related to the repatriation of foreign cash utilized to reduce debt as discussed in Note 9 of the Notes to the Consolidated Financial Statements included in Item 8.
Interest expense was $493,000 and $367,000 in fiscal years 2020 and 2019, respectively. The increase in interest expense for fiscal year 2020 was primarily due to increases in the levels of bank borrowings.
Income tax expense was $1.8 million and $446,000 in fiscal years 2020 and 2019, respectively, or -61.3% and 20.9% of pretax earnings, respectively. The unfavorable effective rate for fiscal year 2020 compared to the prior fiscal year is primarily due to additional tax expense of $2.0 million as a result of the Company’s elimination of its indefinite reinvestment of foreign unremitted earnings and an increase in valuation allowances of $1.7 million, partially offset by the favorable tax benefit of $939,000 for net operating losses to be carried back to prior years with higher enacted tax rates as discussed in Note 5 of the Notes to the Consolidated Financial Statements included in Item 8.
Net earnings attributable to the noncontrolling interest related to our subsidiaries that are not 100% owned by the Company were $63,000 and $159,000 for fiscal years 2020 and 2019, respectively. The changes in the net earnings attributable to the noncontrolling interest for each year were due to changes in the levels of net income of the subsidiaries.
Net loss in fiscal year 2020 was $4,687,000, or $1.70 per diluted share. Net earnings in fiscal year 2019 were $1,529,000, or $0.55 per diluted share. The decrease in earnings was attributable to the factors discussed above.
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of liquidity have historically been funds generated from operating activities, supplemented as needed by borrowings under our revolving credit facility. Additionally, certain machinery and equipment are financed by non-cancelable operating leases. We believe that these sources of funds will be sufficient to support ongoing business requirements, including capital expenditures, through fiscal year 2021.
At April 30, 2020, we had advances of $4.7 million and standby letters of credit aggregating $512,000 outstanding under our unsecured revolving credit facility. On June 19, 2019 we entered into a Security Agreement pursuant to which we granted a security interest in substantially all of our assets to secure our obligations under the credit facility. See Note 4 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report for additional information concerning our credit facility. We did not have any off balance sheet arrangements at April 30, 2020.
The following table summarizes the cash payment obligations for our lease arrangements as of April 30, 2020:
PAYMENTS DUE BY PERIOD
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($ in thousands)
Contractual Cash Obligations
Total
1 Year
2-3 Years
4-5 Years
After 5 years
Operating Leases
$
10,847
$
1,541
$
3,022
$
2,388
$
3,896
Capital Lease Obligations
171
32
64
64
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Total Contractual Cash Obligations
$
11,018
$
1,573
$
3,086
$
2,452
$
3,907
Operating activities provided cash of $4,161,000 in fiscal year 2020, primarily from operations, and decreases in inventories of $1,876,000 and receivables of $4,833,000, partially offset by decreases in accounts payable and accrued expenses of $2,016,000. Operating activities provided cash of $2,490,000 in fiscal year 2019, primarily from operating earnings, and an increase in accounts payable and other accrued expenses, partially offset by increases in inventories and deferred revenue.
The Company’s financing activities used cash of $7,458,000 during fiscal year 2020 for payments on short-term borrowings of $4,794,000, cash dividends of $1,044,000 paid to stockholders, cash dividends of $324,000 paid to minority interest holders and repayment of long-term debt of $1,282,000. The Company’s financing activities provided cash of $2,334,000 during fiscal year 2019 as a result of an increase in short-term borrowings of $5,628,000, which was partially utilized for cash dividends of $2,030,000 paid to stockholders, cash dividends of $51,000 paid to minority interest holders and repayment of long-term debt of $1,177,000. See Note 4 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report for additional information concerning our credit facility.
The majority of the April 30, 2020 accounts receivable balances are expected to be collected during the first quarter of fiscal year 2021, with the exception of retention amounts on fixed-price contracts which are collected when the entire construction project is completed and all retention funds are paid by the owner.
As discussed above, no further benefits have been, or will be, earned under our pension plans after April 30, 2005, and no additional participants have been, or will be, added to the plans. There were no contributions to the plans in fiscal year 2020 and we expect to make contributions of $30,000 to the plans in fiscal year 2021. We made contributions of $1,000,000 to the plans in fiscal year 2019.
Capital expenditures were $2.5 million and $4.2 million in fiscal years 2020 and 2019, respectively. Capital expenditures in fiscal year 2020 were funded primarily from operations. During fiscal 2020, the Company established a strategy for a multi-year transformation of the business, which is designed to lead to sustained profitability and growth. Fiscal year 2021 capital expenditures are anticipated to be approximately $2.0 million, with the majority of these expenditures related to investing in modernizing our manufacturing capabilities and information technology platform. The fiscal year 2021 expenditures are expected to be funded primarily by operating activities, supplemented as needed by borrowings under our revolving credit facility.
Working capital was $27.2 million at April 30, 2020, down from $32.6 million at April 30, 2019, and the ratio of current assets to current liabilities was 2.0-to-1.0 at April 30, 2020 and April 30, 2019. The decrease in working capital for fiscal year 2020 was primarily due to the decrease in cash and accounts receivable partially offset by a decrease in outstanding debt.
We paid cash dividends of $0.38 per share in fiscal year 2020. We paid cash dividends of $0.74 per share in fiscal year 2019. On December 16, 2019, the Company announced that the Board of Directors had elected to suspend the Company's dividend. The declaration and payment of any future dividends will be at the discretion of the Board of Directors and will depend upon many factors, including the Company’s earnings, capital requirements, investment and growth strategies, financial conditions, the terms of the Company’s indebtedness, which currently contains provisions that could limit the payment of dividends in certain circumstances, and other factors that the Board of Directors may deem to be relevant.
RECENT ACCOUNTING STANDARDS
New Accounting Standards
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”). This update outlined a new comprehensive revenue recognition model that supersedes most prior revenue recognition guidance and required companies to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflected the consideration to which the entity expected to be entitled in exchange for those goods or services. The Company adopted this standard effective May 1, 2018.
In February 2016, the FASB issued ASU 2016-02, “Leases.” This guidance establishes a right-of-use ("ROU") model that requires a lessee to record an ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the
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income statement. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. This guidance became effective for fiscal years, and interim periods within those years, beginning after December 15, 2018. The Company adopted this standard effective May 1, 2019. The adoption of ASU 2016-02 resulted in the recognition of ROU assets and corresponding lease liabilities on the Company's consolidated financial position. See Note 8 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report for additional information.
In June 2016, the FASB issued ASU 2016-13, “Measurement of Credit Losses on Financial Instruments,” which replaces the current incurred loss method used for determining credit losses on financial assets, including trade receivables, with an expected credit loss method. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2022. The Company will adopt this standard in fiscal year 2024. The Company does not expect the adoption of this standard to have a significant impact on the Company’s consolidated financial position or results of operations.
In January 2017, the FASB issued ASU 2017-04, “Simplifying the Test for Goodwill Impairment,” which eliminates the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019. The Company will adopt this standard in fiscal year 2021. The Company does not expect the adoption of this standard to have a significant impact on the Company’s consolidated financial position or results of operations.
In March 2017, the FASB issued ASU 2017-07, “Compensation—Retirement Benefits—Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost,” which requires that the service cost component of net periodic pension cost is presented in the same line as other compensation costs arising from services rendered by the respective employees during the year. The other components of net periodic pension cost are required to be presented in the income statement separately from the service cost component and outside of earnings from operations. This guidance allows for the service cost component to be eligible for capitalization when applicable. This guidance became effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. The Company adopted this standard effective May 1, 2018 using the full retrospective approach.
In February 2018, the FASB issued ASU 2018-2, “Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income.” This guidance provides the Company with an option to reclassify stranded tax effects resulting from the Tax Cuts and Jobs Act ("2017 Tax Act") from accumulated other comprehensive income to retained earnings. This guidance became effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted. The Company adopted this standard effective May 1, 2019 and did not elect to reclassify tax effects as a result of tax reform; therefore, the adoption did not have a significant impact on the Company's consolidated financial position or results of operations.
In March 2018, the FASB issued ASU 2018-09, “Compensation - Stock Compensation ("Topic 718"): Improvements to Employee Share-Based Payment Accounting” ("ASU 2018-09"). This ASU makes several modifications to Topic 718 related to the accounting for forfeitures, employer tax withholding on share-based compensation, and the financial statement presentation of excess tax benefits or deficiencies. ASU 2018-09 also clarifies the statement of cash flows presentation for certain components of share-based awards. The standard is effective for interim and annual reporting periods beginning after December 15, 2018, with early adoption permitted. The Company adopted this standard effective May 1, 2019. The adoption of this standard did not have a significant impact on the Company's consolidated financial position or results of operations.
In August 2018, the FASB issued ASU 2018-14, “Compensation -Retirement Benefits -Defined Benefit Plans -General (Subtopic 715-20) - Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans" ("ASU 2018-14"). The amendments in this update remove defined benefit plan disclosures that are no longer considered cost-beneficial, clarify the specific requirements of disclosures, and add disclosure requirements identified as relevant. ASU 2018-14 is effective for fiscal years ending after December 15, 2020. Early adoption is permitted. The Company will adopt this standard in fiscal year 2021. The Company does not expect the adoption of this standard to have a significant impact on the Company’s consolidated financial position or results of operations.
In December 2019, the FASB issued ASU No. 2019-12 , "Income Taxes ("Topic 740"): Simplifying the Accounting for Income Taxes." This update simplifies the accounting for income taxes through certain targeted improvements to various subtopics within Topic 740. The amendments in this update are effective for fiscal years and interim periods beginning after December 15, 2020. The Company expects to adopt this guidance when effective and is currently evaluating the effect that the updated standard will have on its consolidated financial statements and related disclosures.
OUTLOOK
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Financial Outlook
The Company’s ability to predict future demand for its products continues to be limited given its role as subcontractor or supplier to dealers for subcontractors. Demand for the Company’s products is also dependent upon the number of laboratory construction projects planned and/or current progress in projects already under construction. The Company’s earnings are also impacted by fluctuations in prevailing pricing for projects in the laboratory construction marketplace and increased costs of raw materials, including stainless steel, wood, and epoxy resin, and whether the Company is able to increase product prices to customers in amounts that correspond to such increases without materially and adversely affecting sales. Additionally, since prices are normally quoted on a firm basis in the industry, the Company bears the burden of possible increases in labor and material costs between the quotation of an order and delivery of a product. Looking forward, we are optimistic about our opportunities for growth within our existing end-markets and are committed to investing and modernizing our capabilities to succeed.