SIFCO INDUSTRIES INC 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Management’s Discussion and Analysis of Financial Condition and Results of Operations may contain various forward-looking statements and includes assumptions concerning the Company’s operations, future results and prospects. These forward-looking statements are based on current expectations and are subject to risk and uncertainties. In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, the Company provides this cautionary statement identifying important economic, political and technological factors, among others, the absence or effect of which could cause the actual results or events to differ materially from those set forth in or implied by the forward-looking statements and related assumptions. Such factors include the following: (1) the impact on business conditions in general, and on the demand for product in the A&E industries in particular, of the global economic outlook, including the continuation of military spending at or near current levels and the availability of capital and liquidity from banks, the financial markets and other providers of credit; (2) the future business environment, including capital and consumer spending; (3) competitive factors, including the ability to replace business that may be lost at comparable margins; (4) metals and commodities price increases and the Company’s ability to recover such price increases; (5) successful development and market introduction of new products and services; (6) continued reliance on consumer acceptance of regional and business aircraft powered by more fuel efficient turboprop engines; (7) continued reliance on military spending, in general, and/or several major customers, in particular, for revenues; (8) the impact on future contributions to the Company’s defined benefit pension plans due to changes in actuarial assumptions, government regulations and the market value of plan assets; (9) stable governments, business conditions, laws, regulations and taxes in economies where business is conducted; (10) the ability to successfully integrate businesses that may be acquired into the Company’s operations; (11) cyber and other security threats or disruptions faced by us, our customers or our suppliers and other partners; (12) our exposure to additional risks as a result of our international business, including risks related to geopolitical and economic factors, suppliers, laws and regulations; (13) the ability to maintain a qualified workforce; (14) the adequacy and availability of our insurance coverage; (15) our ability to develop new products and technologies and maintain technologies, facilities, and equipment to win new competitions and meet the needs of our customers; (16) our ability to realize amounts in our backlog; (17) investigations, claims, disputes, enforcement actions, litigation and/or other legal proceedings; (18) extraordinary or force majeure events affecting the business or operations of our business; and (19) the impact of the novel COVID-19 pandemic and related impact on the global economy, which may exacerbate the above factors and/or impact our results of operations and financial condition. The Company is engaged in the production of forgings and machined components primarily for the A&E markets. The processes and services provided by the Company include forging, heat-treating, machining, subassembly, and test. The Company operates under one business segment. The Company endeavors to plan and evaluate its business operations while taking into consideration certain factors including the following: (i) the projected build rate for commercial, business and military aircraft, as well as the engines that power such aircraft; (ii) the projected maintenance, repair and overhaul schedules for commercial, business and military aircraft, as well as the engines that power such aircraft; and (iii) the projected build rate and repair for industrial turbines. The Company operates within a cost structure that includes a significant fixed component. Therefore, higher net sales volumes are expected to result in greater operating income because such higher volumes allow the business operations to better leverage the fixed component of their respective cost structures. Conversely, the opposite effect is expected to occur at lower net sales and related production volumes. 16 A. Results of Operations Overview The Company produces forged components for (i) turbine engines that power commercial, business and regional aircraft as well as military aircraft and other military applications; (ii) airframe applications for a variety of aircraft; (iii) industrial gas and steam turbine engines for power generation units; and (iv) other commercial applications. Fire Restoration In the first quarter of fiscal 2021, the insurance claim related to the fire on December 26, 2018 at the Orange location was finalized with the Company's insurance carrier. The Company continues to work diligently to restore the final two of the six presses damaged in the fire, which both continue to be on track to be completed by the end of the second quarter of fiscal 2021; however, no assurances can be made that the restoration will be completed within such timeframe. Restoration of the building structure is nearly complete. Having finalized the claim with its insurance carrier, proceeds in the amount of $3.1 million was received in December 2020. The $3.1 million was recognized within the consolidated condensed statements of operations and the balance was separately designated to the landlord for the continued restoration of the damaged building as prescribed under the lease arrangement. The Company has business interruption insurance coverage, of which $0.5 million of the amount received was reflected within the cost of goods sold line within the consolidated condensed statement of operations. For further detail of how the consolidated condensed statements of operations and balance sheets were impacted for the three months ended, refer to Note 10, Commitments and Contingencies. COVID-19 Since being recognized by the World Health Organization as a pandemic, the novel coronavirus ("COVID-19") outbreak continues to be widespread in the United States and other countries in which we operate. Capital markets and economies worldwide have been negatively impacted by COVID-19 and it is still unclear how lasting and deep the economic impacts will be, specifically with the commercial aerospace industry. During the three months ended December 31, 2020, the COVID-19 pandemic had mixed effects on the Company’s results of operations. The Company continues to actively take measures to reduce costs by furloughing and laying off certain employees from one of its plant locations where reduced sales of commercial aerospace products have occurred, and it may continue to have adverse effects. As such, the Company continues to actively monitor and find ways to mitigate the impact of the pandemic on its operations and consider its ability to pivot its operations and the industries served. Backlog of Orders SIFCO’s total backlog at December 31, 2020 was $81.5 million, compared with $119.5 million as of December 31, 2019. Orders may be subject to modification or cancellation by the customer with limited charges. Sales in the A&E markets continue to be impacted by the COVID-19 pandemic, which has created increased pressure in these markets. If the COVID-19 pandemic continues to have a material impact on the A&E markets, including with regards to our more significant customers, it could materially affect our business and results of operations. Backlog may decline as customers adjust orders in response to the ongoing COVID-19 pandemic and its impact on their operations. Backlog information may not be indicative of future sales. Three Months Ended December 31, 2020 compared with Three Months Ended December 31, 2019 Net Sales Net sales comparative information for the first three months of fiscal 2021 and 2020 is as follows: (Dollars in millions) Three Months Ended December 31, Increase/ (Decrease) Net Sales 2020 2019 Aerospace components for: Fixed wing aircraft $ 9.8 $ 11.3 $ (1.5) Rotorcraft 7.7 6.8 0.9 Energy components for power generation units 6.5 2.7 3.8 Commercial product and other revenue 1.1 5.4 (4.3) Total $ 25.1 $ 26.2 $ (1.1) 17 Net sales for the first three months of fiscal 2021 decreased $1.1 million to $25.1 million, compared with $26.2 million in the comparable period of fiscal 2020. Commercial products and other revenue decreased $4.3 million in the first three months of fiscal 2021 compared to the same period in fiscal 2020, primarily due to timing of orders for the Hellfire II missile program. The energy components for power generation units increased by $3.8 million primarily due to customer order increases. Fixed wing aircraft sales decreased $1.5 million due to timing of customer orders and a decrease in build rates in certain commercial programs, partially offset by increased military programs. The increase in rotorcraft sales is primarily due to increased shipments relating to certain military programs. Commercial net sales were 42.9% of total net sales and military net sales were 57.1% of total net sales in the first three months of fiscal 2021, compared with 38.9% and 61.1%, respectively, in the comparable period in fiscal 2020. Military net sales decreased by $1.7 million to $14.3 million in the first three months of fiscal 2021, compared with $16.0 million in the comparable period of fiscal 2020, primarily due to the timing of orders for the Hellfire II missile program. Commercial net sales increased $0.6 million to $10.8 million in the first three months of fiscal 2021, compared with $10.2 million in the comparable period of fiscal 2020 primarily due to an increase in energy components sales for power generation due to increased customer orders partially offset by decreased build rates in certain commercial programs. Cost of Goods Sold Cost of goods sold decreased by $1.7 million, or 7.6%, to $21.2 million, or 84.4% of net sales, during the first three months of fiscal 2021, compared with $22.9 million or 87.3% of net sales, in the comparable period of fiscal 2020. The decrease was due primarily to cost controlling measures and the non-recurrence of the one-time pension withdrawal liability charge of $0.8 million incurred in the prior year. Another contributing factor to the decrease was the Company received insurance recoveries related to business interruption of $0.5 million, which partially mitigated the $0.4 million of unabsorbed costs incurred from its Orange location due to reduced production. Gross Profit Gross profit increased $0.6 million to $3.9 million during the first three months of fiscal 2021, compared with $3.3 million in the comparable period of fiscal 2020. Gross margin percent of sales was 15.6% during the first three months of fiscal 2021, compared with 12.7% in the comparable period in fiscal 2020. The increase in gross profit was primarily due to the reduced cost of goods sold as outlined above. Selling, General and Administrative Expenses Selling, general and administrative expenses were $3.8 million, or 15.3% of net sales during the first three months of fiscal 2021, compared with $4.2 million, or 16.1% of net sales in the comparable period of fiscal 2020. The decrease in selling, general and administrative expenses is due to the continued cost reduction efforts by management in response to COVID-19 and other effects of the COVID-19 pandemic and its impact on operations such as lower wages related to a first quarter furlough at one location and less travel expense, partially offset by higher legal and professional costs and commissions. Amortization of Intangibles Amortization of intangibles was $0.3 million in the first three months of fiscal 2021, compared with $0.4 million in the comparable period of fiscal 2020. Other/General The Company recorded income before taxes of $2.1 million in the first three months of fiscal 2021, compared with a loss before taxes of $1.4 million in the first three months of fiscal 2020. In the first three months ended December 31, 2020, results included a $2.5 million gain on insurance recoveries, compared to none in the comparable period. Interest expense was $0.2 million in the first three months of fiscal 2021, compared to $0.3 million in the first three months of fiscal 2020. 18 The following table sets forth the weighted average interest rates and weighted average outstanding balances under the Company’s debt agreement in the first three months of both fiscal 2021 and 2020: Weighted Average Interest Rate Three Months Ended December 31, Weighted Average Outstanding Balance Three Months Ended December 31, 2020 2019 2020 2019 Revolving credit agreement 1.5 % 3.6 % $ 10.8 million $ 15.8 million Foreign term debt 3.0 % 2.4 % $ 7.1 million $ 5.9 million Other debt 0.9 % 0.9 % $ 5.8 million $ 1.0 million Income Taxes The Company’s effective tax rate through the first three months of fiscal 2021 was (43)%, compared with 7% for the same period of fiscal 2020. The decrease in the effective rate was primarily attributable to a discrete tax benefit recorded during the first three months of fiscal 2021 to adjust deferred taxes recorded in Italy, applied against year-to-date income. Additionally, the effective tax rate decreased as a result of changes in jurisdictional mix of income in fiscal 2021 compared with the same period of fiscal 2020. The effective tax rate differs from the U.S. federal statutory rate due primarily to the valuation allowance against the Company’s U.S. deferred tax assets and income in foreign jurisdictions that are taxed at different rates than the U.S. statutory tax rate. Net Income (Loss) Net income was $2.9 million during the first three months of fiscal 2021, compared with a net loss of $1.3 million in fiscal 2020, respectively. The increase in income is primarily due to higher gross profit, attributed to continued cost saving activities, insurance recoveries received in the first three months of fiscal 2021, the favorable tax benefit as described above, and lower selling, general and administrative expenses. Non-GAAP Financial Measures Presented below is certain financial information based on the Company's EBITDA and Adjusted EBITDA. References to “EBITDA” mean earnings (losses) from continuing operations before interest, taxes, depreciation and amortization, and references to “Adjusted EBITDA” mean EBITDA plus, as applicable for each relevant period, certain adjustments as set forth in the reconciliations of net income to EBITDA and Adjusted EBITDA. Neither EBITDA nor Adjusted EBITDA is a measurement of financial performance under generally accepted accounting principles in the United States of America (“GAAP”). The Company presents EBITDA and Adjusted EBITDA because management believes that they are useful indicators for evaluating operating performance and liquidity, including the Company’s ability to incur and service debt and it uses EBITDA to evaluate prospective acquisitions. Although the Company uses EBITDA and Adjusted EBITDA for the reasons noted above, the use of these non-GAAP financial measures as analytical tools has limitations. Therefore, reviewers of the Company’s financial information should not consider them in isolation, or as a substitute for analysis of the Company's results of operations as reported in accordance with GAAP. Some of these limitations include: • Neither EBITDA nor Adjusted EBITDA reflects the interest expense, or the cash requirements necessary to service interest payments on indebtedness; • Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and neither EBITDA nor Adjusted EBITDA reflects any cash requirements for such replacements; • The omission of the substantial amortization expense associated with the Company’s intangible assets further limits the usefulness of EBITDA and Adjusted EBITDA; and • Neither EBITDA nor Adjusted EBITDA includes the payment of taxes, which is a necessary element of operations. Because of these limitations, EBITDA and Adjusted EBITDA should not be considered as measures of discretionary cash available to the Company to invest in the growth of its businesses. Management compensates for these limitations by not viewing EBITDA or Adjusted EBITDA in isolation and specifically by using other GAAP measures, such as net income (loss), net sales, and operating income (loss), to measure operating performance. Neither EBITDA nor Adjusted EBITDA is a measurement of financial performance under GAAP, and neither should be considered as an alternative to net loss or cash flow from operations determined in accordance with GAAP. The Company’s calculation of EBITDA and Adjusted EBITDA may not be comparable to the calculation of similarly titled measures reported by other companies. 19 The following table sets forth a reconciliation of net loss to EBITDA and Adjusted EBITDA: Dollars in thousands Three Months Ended December 31, 2020 2019 Net income (loss) $ 2,993 $ (1,342) Adjustments: Depreciation and amortization expense 1,825 1,856 Interest expense, net 165 251 Income tax benefit (905) (95) EBITDA 4,078 670 Adjustments: Foreign currency exchange loss, net (1) 7 1 Other income, net (2) 62 (108) Gain on insurance recoveries (3) (2,495) — Equity compensation (4) 143 155 LIFO impact (5) 128 22 Adjusted EBITDA $ 1,923 $ 740 (1) Represents the gain or loss from changes in the exchange rates between the functional currency and the foreign currency in which the transaction is denominated. (2) Represents miscellaneous non-operating income or expense, such as pension costs or grant income. (3) Represents the difference between the insurance proceeds received for the damaged property and the carrying values shown on the Company's books for the assets that were damaged in the fire at the Orange location. (4) Represents the equity-based compensation expense recognized by the Company under the 2016 Plan due to granting of awards, awards not vesting and/or forfeitures. (5) Represents the change in the reserve for inventories for which cost is determined using the last-in, first-out (“LIFO”) method. B. Liquidity and Capital Resources Historically, the main sources of liquidity have been cash flows from operations and borrowings under our Credit Agreement. However, the ongoing impact of the COVID-19 pandemic (and the rapidly changing U.S. and global market and economic conditions due to the COVID-19 outbreak) remain uncertain, with the commercial aerospace market continuing to be impacted by the global disruption in travel and, further, the pandemic and responses to the continued spread of the pandemic causing continued interruptions to the business of our customers and suppliers, which in turn is likely to impact our business, operations and results as well as our liquidity and capital resources. The Company's liquidity could be negatively affected by customers extending payment terms to the Company and/or the decrease in demand for our products as a result of the impact of the COVID-19 on the commercial airline industry. As the impact of the COVID-19 pandemic on the economy and the Company's operations continues to evolve, the Company and management will continue to assess liquidity needs. Cash and cash equivalents was $1.2 million at December 31, 2020 and $0.4 million at September 30, 2020. At December 31, 2020, $0.8 million of the Company’s cash and cash equivalents were in the possession of its non-U.S. subsidiaries. Distributions from the Company's non-U.S. subsidiaries to the Company may be subject to adverse tax consequences. Operating Activities The Company’s operating activities provided $3.1 million of cash in the first three months of fiscal 2021, compared with usage of cash of $1.0 million in the first three months of fiscal 2020. The cash provided in fiscal 2021 was primarily due to net income of $2.9 million and $1.4 million decrease in working capital, partially offset by $1.2 million in non-cash items, such as gain on insurance recovery and deferred income taxes, depreciation and amortization, equity based compensation, and LIFO effect. The cash provided from working capital was primarily due to decrease in receivables due to customer collections and decreased accrued liabilities. The Company’s operating activities used $1.0 million of cash in the first three months of fiscal 2020. The cash used by operating activities in the first three months of fiscal 2020 was primarily due to an increase in working capital of $1.4 million and net loss of $1.3 million, partially offset by $1.8 million of non-cash items such as depreciation and amortization of $1.9 million, and other non-cash items, such as equity based compensation, deferred income taxes and LIFO effect. The use of cash 20 from working capital was primarily due to increase in inventories and payments to suppliers, partially offset by decreased receivables resulting from collections. Investing Activities Cash used for investing activities was $0.3 million in the first three months of fiscal 2021, which includes $3.5 million of insurance recovery on the damaged property related to the fire at the Orange location, compared with cash provided for investing activities of $1.2 million in the first three months of fiscal 2020. Capital expenditures were $3.7 million, of which $3.2 million related to the continued restoration of the Orange location as a result of the fire. In addition to the $3.7 million spent for capital expenditures during the first three months of fiscal 2021, $1.6 million was committed for future capital expenditures as of December 31, 2020. The Company anticipates that the total fiscal 2021 capital expenditures will be within the range of $2.5 million to $4.5 million (exclusive of fire related expenditures) and will relate principally to the further enhancement of production and product offering capabilities and operating cost reductions. Separate from the amounts given above, the Company anticipates incurring additional costs in fiscal 2021 of approximately $1.0 million to $1.5 million in capital expenditures at the Orange location as the result of the fire and resulting damage that took place. These costs are expected to be offset by the insurance proceeds received. Financing Activities Cash used by financing activities was $2.1 million in the first three months of fiscal 2021, compared with cash used by financing activities of $0.2 million in the first three months of fiscal 2020. The Company had net repayments from the revolver under the Credit Agreement of $3.7 million in the first three months of fiscal 2021 and net borrowings of $1.1 million in the first three months of fiscal 2020. Under the Company's Credit Agreement, the Company is subject to certain customary loan covenants regarding availability as discussed in Note 5, Debt. The availability at December 31, 2020 was $16.8 million. If availability had fallen short, the Company would be required to meet the fixed charge coverage ratio ("FCCR") covenant, which must not be less than 1.1 to 1.0. In the event of a default, we may not be able to access our revolver, which could impact the ability to fund working capital needs, capital expenditures and invest in new business opportunities. Because the availability was greater than the 12.5% of the Revolving Commitment as of December 31, 2020, the FCCR calculation was not required. As the Company’s Credit Agreement is asset-based, a sustained significant decrease in revenue in the U.S. or excessive aging of the underlying receivables as a result of the impact of the COVID-19 pandemic could materially affect the collateral capacity limitation of the availability under the Credit Agreement and could impact our ability to comply with covenants in our Credit Agreement. Future cash flows from the Company’s operations may be used to pay down amounts outstanding under the Credit Agreement and its foreign related debts. The Company believes it has adequate cash/liquidity available to finance its operations from the combination of (i) the Company’s expected cash flows from operations and (ii) funds available under the Credit Agreement for its domestic locations. The Company was able to defer payments for certain debt obligations at its Maniago location to provide Maniago with sufficient liquidity. The Company's current Credit Agreement is set to mature within the next twelve months. As such, the Company’s plan is to refinance. However, there are no guarantees that the refinance will be with similar terms to the current Credit Agreement, and if the refinance does not occur, the Company would not be able to meet its debt obligations. Additionally, the credit and capital markets has seen significant volatility. Tightening of the credit market and standards, as well as capital market volatility, could negatively impact our ability to obtain additional debt financing on terms equivalent to our existing Credit Agreement, in the event the Company seeks additional liquidity sources as a result of the continued impact of COVID-19. Capital market uncertainty and volatility, together with the Company’s market capitalization and status as a smaller reporting company could also negatively impact our ability to obtain equity financing. D. Impact of Recently Issued Accounting Standards In June 2016, the FASB issued ASU 2016-13, " Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments " and subsequent updates. ASU 2016-13 changes how entities will measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. The new guidance will replace the current incurred loss approach with an expected loss model. The new expected credit loss impairment model will apply to most financial assets measured at amortized cost and certain other instruments, including trade and other receivables, loans, held-to-maturity debt instruments, net investments in leases, loan commitments and standby letters of credit. Upon initial recognition of the exposure, the expected credit loss model requires entities to estimate the credit losses expected over the life of an exposure (or pool of exposures). The estimate of expected credit losses should consider historical 21 information, current information and reasonable and supportable forecasts, including estimates of prepayments. Financial instruments with similar risk characteristics should be grouped together when estimating expected credit losses. ASU 2016-13 does not prescribe a specific method to make the estimate, so its application will require significant judgment. ASU 2016-13 is effective for public companies in fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. However, in November 2019, the FASB issued ASU 2019-10, "Financial Instruments - Credit Loss (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842)," which defers the effective date for public filers that are considered smaller reporting companies ("SRC"), as defined by the Securities and Exchange Commission, to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Because SIFCO is considered a SRC, the Company does not need to implement until October 1, 2023. The Company will continue to evaluate the effect of adopting ASU 2016-13 will have on the Company's results within the consolidated condensed statements of operations and financial condition. In December 2019, ASU 2019-12, " Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes" was issued to (i) reduce the complexity of the standard by removing certain exceptions to the general principles in Topic 740 and (ii) improve consistency and simplify other areas of Topic 740 by clarifying and amending existing guidance. This ASU is effective beginning October 1, 2021. The Company is currently in the process of evaluating the impact of adoption of the rules on the Company's financial condition, results of operations and disclosure.