Omega Flex, Inc. 10-Q

Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations This report contains forward-looking statements, which are subject to inherent uncertainties. These uncertainties include, but are not limited to, variations in weather, changes in the regulatory environment, customer preferences, general economic conditions, increased competition, the outcome of outstanding litigation, and future developments affecting environmental matters. All of these are difficult to predict, and many are beyond the ability of the Company to control. Certain statements in this Quarterly Report on Form 10-Q that are not historical facts, but rather reflect the Company’s current expectations concerning future results and events, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words “believes”, “expects”, “intends”, “plans”, “anticipates”, “hopes”, “likely”, “will”, and similar expressions identify such forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause the actual results, performance or achievements of the Company, or industry results, to differ materially from future results, performance or achievements expressed or implied by such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s view only as of the date of this Form 10-Q. The Company undertakes no obligation to update the result of any revisions to these forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events, conditions, or circumstances. OVERVIEW The Company is a leading manufacturer of flexible metal hose and is currently engaged in a number of different markets, including construction, manufacturing, transportation, petrochemical, pharmaceutical and other industries. The Company’s business is managed as a single operating segment that consists of the manufacture and sale of flexible metal hose, fittings, and accessories. The Company’s products are concentrated in residential and commercial construction, and general industrial markets, with a comprehensive portfolio of intellectual property and patents issued in various countries around the world. The Company’s primary product, flexible gas piping, is used for gas piping within residential and commercial buildings. Through its flexibility and ease of use, the Company’s TracPipe ® and TracPipe ® CounterStrike ® flexible gas piping, along with its fittings distributed under the trademarks AutoSnap ® and AutoFlare ® , allows users to substantially cut the time required to install gas piping, as compared to traditional methods. The Company’s newest product line MediTrac ® corrugated medical tubing is used for piping medical gases (oxygen, nitrogen, nitrous oxide, carbon dioxide, and medical vacuum) in health care facilities. Building on the recognized strengths and strategies employed in the flexible gas piping market, MediTrac ® can be used in place of rigid copper pipe, and due to its long continuous lengths and flexibility, it can be installed approximately five times faster than rigid copper pipe, saving on installation labor and construction schedules. The Company’s products are manufactured at its Exton, Pennsylvania and Houston, Texas facilities in the U.S., and in Banbury, Oxfordshire in the U.K. A majority of the Company’s sales across all industries are generated through independent outside sales organizations such as sales representatives, wholesalers and distributors, or a combination of both. The Company has a broad distribution network in North America and to a lesser extent in other global markets. - 26 - CHANGES IN FINANCIAL CONDITION For the period ended September 30, 2022 vs. December 31, 2021 The Company’s cash balance of $30,569,000 on September 30, 2022 decreased $2,344,000 (7.1%) from a balance of $32,913,000 as of December 31, 2021 mainly because of dividends paid of $6,258,000 partially offset by cash provided by operating activities of $4,569,000. See the Company’s Condensed Consolidated Cash Flow Statements for further details regarding the change in cash. Inventory was $21,827,000 and $15,565,000 as of September 30, 2022 and December 31, 2021, respectively, increasing $6,262,000 or 40.2%. The increase is mainly the result of the purchase of inventory to ensure enough materials on hand because of the challenging supply chain environment and significantly increased costs. Other Current Assets were $4,615,000 on September 30, 2022, compared to $2,533,000 as of December 31, 2021, increasing $2,082,000 or 82.2%. The increase is mainly the result of the prepayment of annual business insurance premiums for the upcoming annual period. Accrued Compensation was $2,897,000 on September 30, 2022, compared to $7,008,000 on December 31, 2021, decreasing $4,111,000 or 58.7%. A significant portion of the liability that existed at the previous year end related to incentive compensation earned in 2021. As is customary, the liability was then paid during the first quarter of the following year, or 2022, thus diminishing the balance. In the current year there was a decrease in the incentive compensation liability to align with the changes in the executive management team. The liability now represents amounts earned during the current year. Accrued Commissions and Sales Incentives were $4,765,000 and $7,183,000 as of September 30, 2022 and December 31, 2021, respectively, decreasing $2,418,000 or 33.7%. A portion of the decrease relates to a lower level of sales during the current quarter in comparison to the fourth quarter of the previous year, and the resulting commissions and sales incentives that are earned. Additionally, a portion of the sales incentives have an annual component which accumulates during the year and are then paid during the first quarter of the following year. Other Liabilities were $7,079,000 and $4,864,000 as of September 30, 2022 and December 31, 2021, respectively. The increase of $2,215,000 or 45.5% mainly relates to accruals for legal and product liability matters which the Company continues to vigorously defend. - 27 - Retained earnings were $58,005,000 and $50,053,000 as of September 30, 2022 and December 31, 2021, respectively, increasing $7,952,000 or 15.9%. The increase was primarily due to net income during the year, as provided on the Company’s Condensed Consolidated Statements of Income, partially offset by dividends declared during 2022, as discussed in detail in Note 8, Shareholders’ Equity, to the Condensed Consolidated Financial Statements included in this report. RESULTS OF OPERATIONS Three months ended September 30, 2022 vs. September 30, 2021 The Company reported comparative results from operations for the three months ended September 30, 2022 and 2021 as follows: Three months ended September 30, (in thousands) 2022 2022 2021 2021 ($000) % ($000) % Net Sales $ 31,629 100.0 % $ 31,725 100.0 % Gross Profit $ 19,757 62.5 % $ 20,039 63.2 % Operating Profit $ 8,641 27.3 % $ 8,326 26.2 % Net Sales. The Company’s 2022 third quarter sales of $31,629,000 decreased $96,000 or 0.3% compared to the third quarter of 2021, which generated sales of $31,725,000. Although sales are consistent with the previous period, sales unit volumes were lower. The effect of the lower sales volumes was largely offset by pricing actions to offset material cost pressure and to protect margins. Gross Profit. The Company’s gross profit margins were 62.5% and 63.2% for the three months ended September 30, 2022 and 2021, respectively. Selling Expenses . Selling expenses consist primarily of employee salaries and associated overhead costs, commissions, and the cost of marketing programs such as advertising, trade shows and related communication costs, and freight. Selling expense was $5,261,000 and $4,876,000 for the three months ended September 30, 2022 and 2021, respectively, representing an increase of $385,000 or 7.9%. The increases mostly related to commissions, staffing related expenses, and costs for resumption of travel and other marketing efforts, which were lower in the 2021 period due to the pandemic, partially offset by lower freight. Selling expenses increased as a percent of net sales compared to last year, being 16.6% for the three months ended September 30, 2022, and 15.4% for the three months ended September 30, 2021. - 28 - General and Administrative Expenses . General and administrative expenses consist primarily of employee salaries, benefits for administrative, executive and finance personnel, legal and accounting, and corporate general and administrative services. General and administrative expenses were $4,754,000 and $5,724,000 for the three months ended September 30, 2022 and 2021, respectively, thus decreasing by $970,000 or 16.9%. There was a decrease in the incentive compensation component which is aligned with profitability of $1,774,000 to align with the changes in the executive management team. There also was a reduction in stock-based compensation expense which moves in relation to the Company’s stock price, as detailed in Note 6, Stock-Based Compensation Plans, to the Condensed Consolidated Financial Statements included in this report. Higher items include product liability reserves and expenses, associated primarily with one pending case, which the Company continues to vigorously defend, and staffing related expenses. As a percentage of sales, general and administrative expenses decreased to 15.0% for the three months ended September 30, 2022 from 18.0% for the three months ended September 30, 2021. Engineering Expense . Engineering expenses consist of development expenses associated with the development of new products and enhancements to existing products, and manufacturing engineering costs. Engineering expenses were $1,101,000 and $1,113,000 for the three months ended September 30, 2022 and 2021, respectively, decreasing by $12,000 or 1.1%. Engineering expenses as a percentage of sales were 3.5% for the three months ended September 30, 2022 and 2021. Operating Profits . Reflecting all of the factors mentioned above, operating profits were $8,641,000 and $8,326,000 for the three months ended September 30, 2022 and 2021, respectively, increasing by $315,000 or 3.8%. Interest Income. Interest income is recorded on cash investments, and interest expense is recorded at times when the Company has debt amounts outstanding on its line of credit. The Company recorded $32,000 of interest income for the three months ended September 30, 2022 and $10,000 for the three months ended September 30, 2021. Other Income (Expense) . Other income (expense) primarily consists of foreign currency exchange gains (losses) on transactions settled in currencies other than the Company’s local currency, typically related to the Company’s foreign U.K. subsidiaries. There were losses of $210,000 and $19,000 recorded during the three months ended September 30, 2022 and 2021 respectively. The British Pound had weakened during each of the third quarters of 2022 and 2021. As a percentage of sales, other expenses increased to 0.7% for the three months ended September 30, 2022 from 0.1% for the three months ended September 30, 2021. Income Tax Expense . Income tax expense was $1,924,000 for the three months ended September 30, 2022, compared to $2,160,000 for the same period in 2021, decreasing $236,000 or 10.9%, mostly because of the reduction of non-deductible incentive compensation to align with the changes in the executive management team. - 29 - Nine months ended September 30, 2022 vs. September 30, 2021 The Company reported comparative results from operations for the nine months ended September 30, 2022 and 2021 as follows: Nine months ended September 30, (in thousands) 2022 2022 2021 2021 ($000) % ($000) % Net Sales $ 94,670 100.0 % $ 94,554 100.0 % Gross Profit $ 59,665 63.0 % $ 59,296 62.7 % Operating Profit $ 23,349 24.7 % $ 25,064 26.5 % Net Sales. The Company’s sales for the first nine months of 2022 of $94,670,000 increased $116,000 or 0.1% compared to the first nine months of 2021, which generated sales of $94,554,000. Although sales are consistent with the previous period, sales unit volumes were lower. The effect of the lower sales volumes was largely offset by pricing actions to offset material cost pressure and to protect margins. Gross Profit. The Company’s gross profit margins were 63.0% and 62.7% for the nine months ended September 30, 2022 and 2021, respectively. Selling Expenses . Selling expenses consist primarily of employee salaries and associated overhead costs, commissions, and the cost of marketing programs such as advertising, trade shows and related communication costs, and freight. Selling expense was $16,545,000 and $14,625,000 for the nine months ended September 30, 2022 and 2021, respectively, representing an increase of $1,920,000 or 13.1%. The increases primarily related to costs for resumption of travel and other marketing efforts, which were lower in the 2021 period due to the pandemic. Commissions and staffing related expenses were also higher. Commissions increased partly because of a shift of shipments from third party warehouses, whose shipments are subject to commission, compared to those directly from the manufacturing facilities, whose shipments are not subject to commission. Selling expenses increased as a percent of net sales compared to last year, being 17.5% for the nine months ended September 30, 2022, and 15.5% for the nine months ended September 30, 2021. General and Administrative Expenses . General and administrative expenses consist primarily of employee salaries, benefits for administrative, executive and finance personnel, legal and accounting, and corporate general and administrative services. General and administrative expenses were $16,257,000 and $16,281,000 for the nine months ended September 30, 2022 and 2021, respectively, thus decreasing by $24,000 or 0.1%. There was a decrease in the incentive compensation component which is aligned with profitability of $2,167,000 to align with the changes in the executive management team and there was a reduction in stock-based compensation expense which moves in relation to the Company’s stock price, as detailed in Note 6, Stock-Based Compensation Plans, to the Condensed Consolidated Financial Statements included in this report. Higher items higher product liability reserves and expenses of $2,159,000 associated primarily with two pending cases, which the Company continues to vigorously defend, and staffing related expenses. As a percentage of sales, general and administrative expenses were 17.2% for the nine months ended September 30, 2022 and 2021. - 30 - Engineering Expense . Engineering expenses consist of development expenses associated with the development of new products and enhancements to existing products, and manufacturing engineering costs. Engineering expenses were $3,514,000 and $3,326,000 for the nine months ended September 30, 2022 and 2021, respectively, increasing by $188,000 or 5.7%, mainly associated with increases in experimental materials and travel. Engineering expenses increased as a percentage of sales, being 3.7% for the nine months ended September 30, 2022, and 3.5% for the same period in 2021. Operating Profits . Reflecting all of the factors mentioned above, operating profits were $23,349,000 and $25,064,000 for the nine months ended September 30, 2022 and 2021, respectively, decreasing by $1,715,000 or 6.8%. Interest Income. Interest income is recorded on cash investments, and interest expense is recorded at times when the Company has debt amounts outstanding on its line of credit. The Company recorded $52,000 and $27,000 of interest income during the first nine months of 2022 and 2021, respectively. Other Income (Expense) . Other Income (Expense) primarily consists of foreign currency exchange gains (losses) on transactions settled in currencies other than the Company’s local currency, typically related to the Company’s foreign U.K. subsidiaries. There was a loss of $374,000 recorded during the first nine months of 2022, but a gain of $6,000 during the first nine months of 2021. The British Pound had weakened during the first nine months of 2022. As a percentage of sales, other expenses increased to 0.4% for the nine months ended September 30, 2022. Income Tax Expense . Income Tax Expense was $5,558,000 for the first nine months of 2022, compared to $6,441,000 for the same period in 2021, decreasing $883,000 or 13.7%, because of the decrease in income before taxes and from the reduction of non-deductible incentive compensation to align with the changes in the executive management team. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of our financial condition and results of operations are based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis. Estimates are used for, but not limited to, revenue recognition and related sales incentives, provisions for credit losses, inventory reserves, valuation of goodwill, product liability reserves, valuation of phantom stock, and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We believe our judgments related to these accounting estimates are appropriate. Actual results may differ from these estimates under different assumptions or conditions. - 31 - Revenue Recognition The Company’s accounting policy relating to revenue recognition reflects the impact of the adoption of Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers (“ASC 606”), which is discussed further in the Notes to the Condensed Consolidated Financial Statements. As a result of the adoption of ASC 606, the Company records revenue based upon a five-step approach. The Company sells goods on typical, unmodified free on board (FOB) shipping point terms. As the seller, it can be determined that the shipped goods meet the agreed-upon specifications in the contract or customer purchase order (e.g. items, quantities, and prices) with the buyer, so customer acceptance would be deemed a formality, as noted in ASC 606-10-55-86. As a result, the Company has a legal right to payment upon shipment of the goods. Based upon the above, the Company has concluded that transfer of control substantively transfers to the customer upon shipment. Other than standard product warranty provisions, the sales arrangements provide for no other post-shipment obligations. The Company offers rebates and other sales incentives, promotional allowances, or discounts to certain customers, typically related to purchase volume, and are classified as a reduction of revenue and recorded at the time of sale. The Company periodically evaluates whether an allowance for sales returns is necessary. Historically, the Company has experienced minimal sales returns. If it is believed there are to be material potential sales returns, the Company will provide the necessary provision against sales. Provision for Credit Losses The Company maintains allowances for credit losses, which represent an estimate of expected losses over the remaining contractual life of its receivables considering current market conditions and estimates for supportable forecasts when appropriate. The estimate is a result of the Company’s ongoing assessments and evaluations of collectability, historical loss experience, and future expectations in estimating credit losses in its receivable portfolio. For accounts receivables, the Company uses historical loss experience rates and applies them to a related aging analysis while also considering customer and/or economic risk where appropriate. Determination of the proper amount of allowances requires management to exercise judgment about the timing, frequency and severity of credit losses that could materially affect the provision for credit losses and, as a result, net earnings. The allowances consider numerous quantitative and qualitative factors that include receivable type, historical loss experience, delinquency trends, collection experience, current economic conditions, estimates for supportable forecasts, when appropriate, and credit risk characteristics. Changes in allowances may occur in the future as the above referenced quantitative and qualitative factors change. Inventories Inventories are valued at the lower of cost or net realizable value. The cost of inventories is determined by the first-in, first-out (FIFO) method. The Company generally considers inventory quantities beyond two years of usage, measured on a historical usage basis, to be excess inventory and reduces the carrying value of inventory accordingly. These reductions to the inventory carrying values are estimates, which could vary significantly, either favorably or unfavorably, from actual amounts if future economic conditions, sales levels, or competitive conditions change. - 32 - Goodwill In accordance with Financial Accounting Standards Board (“FASB”) ASC Topic 350, Intangibles – Goodwill and Other (ASU 2017-04) , using the simplified method as adopted, the Company performed an annual impairment test as of December 31, 2021. This test did not indicate any impairment of goodwill as the Company’s estimated fair value of the reporting unit exceeded carrying value. The test may be performed more frequently if we believe indicators of impairment might exist. These indicators may include changes in macroeconomic and industry conditions, overall financial performance, and other relevant entity-specific events. Product Liability Reserves Product liability reserves represent the estimated unpaid amounts under the Company’s insurance policies with respect to existing claims. The Company uses the most current available data to estimate claims. As explained more fully under Note 5, Commitments and Contingencies, to the Condensed Consolidated Financial Statements included in this report for various product liability claims covered under the Company’s general liability insurance policies, the Company must pay certain defense and settlement costs within its deductible or self-insured retention limits, ranging primarily from $25,000 to $3,000,000 per claim, depending on the terms of the policy in the applicable policy year, up to an aggregate amount. The Company is vigorously defending against all known claims. It is possible that the Company may incur increased litigation costs in the future due to a variety of factors, including a higher number of claims, higher legal costs, and higher insurance deductibles or retentions. Litigation is subject to many uncertainties and management is unable to predict the outcome of the pending suits and claims. From time to time, depending upon the nature of a particular case, the Company may decide to spend more than a deductible or retention to enable more discretion regarding the defense, although this is not common. It is possible that the results of operations or liquidity of the Company, as well as the Company’s ability to procure reasonably priced insurance, could be adversely affected by the pending litigation, potentially materially. The Company is currently unable to estimate the ultimate liability, if any, that may result from the pending litigation, or potential litigation from future claims or claims that have not yet come to our attention, and accordingly, the liability in the Condensed Consolidated Financial Statements primarily represents an accrual for legal costs for services previously rendered, settlements for Claims not yet paid, and anticipated settlements for claims within the Company’s remaining retention under its insurance policies. Stock-Based Compensation Plans In 2006, the Company adopted a Phantom Stock Plan (the “Plan”), which allows the Company to grant phantom stock units (“Units”) to certain key employees, officers, or directors. The Units each represent a contractual right to payment of compensation in the future based upon the market value of the Company’s common stock and are accordingly recorded as liabilities. The Units follow a vesting schedule over three years from the grant date and are then paid upon maturity. In accordance with FASB ASC Topic 718, Compensation - Stock Compensation (“Topic 718”), the Company uses the Black-Scholes option pricing model as its method for determining the fair value of the Units. The liabilities for the Units are adjusted to market value over time from the grant dates to the related maturity dates. The Company recognizes the reversal of any previously recognized compensation expense on forfeited nonvested Units in the period the Units are forfeited. - 33 - The Plan has been amended and restated, for all grants made starting January 1, 2023, to set the vesting method to three-year cliff vesting following the grant date, with full value paid upon maturity. Additionally, for grants made starting January 1, 2023, upon retirement at age 67 or greater, and with one year of continuous service prior to retirement, vesting of the issued grant(s) would accelerate on a pro-rata basis, 1/3 per year from the grant date. Further details of the Plan are provided in Note 6, Stock-Based Compensation Plans, to the Condensed Consolidated Financial Statements included in this report. Any significant changes in the Company’s stock price may have a material impact upon the valuation of the Units. Income Taxes The Company accounts for tax liabilities in accordance with the FASB ASC Topic 740, Income Taxes . Under this method the Company recorded tax expense and related deferred taxes and tax benefits. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities from a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided for deferred tax assets if it is more likely than not that these items will either expire before the Company is able to realize the benefit, or that future deductibility is uncertain. The Company’s accounting for deferred tax consequences represents the best estimate of those future events. Changes in estimates, due to unanticipated events or otherwise, could have a material effect on the financial condition and results of operations of the Company. The Company continually evaluates its deferred tax assets to determine if a valuation allowance is required. LIQUIDITY AND CAPITAL RESOURCES Historically, the Company’s primary cash needs have been related to working capital items, which the Company has largely funded through cash generated from operations. As of September 30, 2022, the Company had a cash balance of $30,569,000. Additionally, the Company has a $15,000,000 line of credit available, as discussed in detail in Note 4, which had no borrowings outstanding upon it on September 30, 2022. On December 31, 2021, the Company had a cash balance of $32,913,000, with no borrowings against the line of credit. - 34 - Operating Activities Cash provided or used by operating activities is net income adjusted for certain non-cash items and changes in certain assets and liabilities, such as those included in working capital. For the nine months ended September 30, 2022, the Company’s operating activities provided cash of $4,569,000, compared to the nine months ended September 30, 2021 which provided cash of $13,164,000, a difference of $8,595,000. For details of the operating cash flows refer to the Condensed Consolidated Statements of Cash Flows in Part I – Financial Information on page eight. As a general trend, the Company tends to deplete or generate lower amounts of cash early in the year, as significant payments are typically made for accrued promotional incentives and incentive compensation. Cash has then historically shown a tendency to be restored and accumulated during the latter portion of the year. Investing Activities Cash used in investing activities during the nine months ended September 30, 2022 and 2021 was $817,000 and $720,000, respectively for capital expenditures. Financing Activities All financing activities relate to dividend payments, which are detailed in Note 8, Shareholders’ Equity. Dividend payments through the first nine months of 2022 and 2021 amounted to $6,258,000 and $8,809,000, respectively. Liquidity We believe our existing cash and cash equivalents, along with our borrowing capacity, will be sufficient to meet our anticipated cash needs for at least the next twelve months. Our future capital requirements will depend upon many factors including our rate of revenue growth, the timing and extent of any expansion efforts, and the potential for investments in, or the acquisition of any complementary products, businesses, or supplementary facilities for additional capacity. CONTINGENT LIABILITIES AND GUARANTEES See Note 5 to the Company’s Condensed Consolidated Financial Statements. OFF-BALANCE SHEET ARRANGEMENTS None. - 35 -