Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
SIFCO is engaged in the production of forgings and machined and sub-assembled components primarily for the A&E markets. The processes and services include forging, heat-treating and machining. The Company operates under one business segment.
When planning and evaluating its business operations, the Company takes 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 build rate for industrial steam and gas turbine engines; and (iii) the projected maintenance, repair and overhaul schedules for commercial, business and military aircraft, as well as the engines that power such aircraft.
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.
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 armored military vehicles; (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
The insurance claim related to the fire on December 26, 2018 at the Orange location was finalized with the Company's insurance carrier. In the third quarter of fiscal 2021, the Company completed the restoration of the final two of the six presses damaged in the fire, and all six presses are currently in operation. Restoration of the building structure was completed as of September 30, 2021.
Having finalized the claim with its insurance carrier, cash proceeds of $4.5 million were received in fiscal 2021. A total of $3.0 million was recognized within the consolidated statements of operations. 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
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statement of operations. See Note 11, Commitments and Contingencies, of the consolidated financial statements to see how the insurance claim impacted the consolidated statements of operations and balance sheets.
COVID-19
As previously noted, the COVID-19 pandemic continues to impact the United States and other countries in which the Company operates. During fiscal 2021, the COVID-19 pandemic continued to impact the Company’s results of operations. Given the long lead times for certain of the Company's products, the Company has seen a greater impact related to the effects of COVID-19 on orders and deliveries in fiscal 2021 than in fiscal 2020. In response to the uncertain environment created by the COVID-19 pandemic, the Company has, in prior periods, taken measures to reduce costs by furloughing and laying off certain of its employees from one of its plant locations that has experienced reduced sales of commercial aerospace products. Such employees have since returned to work. 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.
Fiscal Year 2021 Compared with Fiscal Year 2020
Net Sales
Net sales comparative information for fiscal 2021 and 2020, respectively, is as follows:
(Dollars in millions) Years Ended
September 30, Increase
(Decrease)
Net Sales 2021 2020
Aerospace components for:
Fixed wing aircraft $ 38.5 $ 52.0 $ (13.5)
Rotorcraft 27.2 31.5 (4.3)
Energy components for power generation units 20.4 16.7 3.7
Commercial product and other revenue 13.5 13.4 0.1
Total $ 99.6 $ 113.6 $ (14.0)
Net sales in fiscal 2021 decreased 12.3%, or $14.0 million to $99.6 million, compared with $113.6 million in fiscal 2020. Given the long lead times for certain of the Company's products, the Company has seen a greater impact related to the effects of COVID-19 on orders and deliveries in fiscal 2021 than in fiscal 2020. Fixed wing aircraft sales decreased $13.5 million compared with the same period last year due to timing of customer orders and a decrease in build rates in certain commercial programs as the rebound in air travel did not occur as quickly as anticipated, partially offset by increased sales for military programs. Rotorcraft sales decreased $4.3 million in fiscal 2021 compared to the same period in fiscal 2020 primarily due to revenue recognized over time for certain military applications. The energy components for power generation units increased $3.7 million compared with the same period last year due to customer order increases as the market saw some recovery.
Commercial net sales were 36.7% of total net sales and military net sales were 63.3% of total net sales in fiscal 2021, compared with 42.6% and 57.4%, respectively, in the comparable period in fiscal 2020. Commercial net sales (which includes energy components) decreased $11.7 million to $36.6 million in fiscal 2021, compared to $48.3 million in fiscal 2020 primarily due to the decrease in build rates in the commercial aerospace industry, partially offset by an increase in energy component sales for power generation due to increased customer orders. Military net sales decreased $2.2 million to $63.0 million in fiscal 2021, compared to $65.2 million in fiscal 2020 primarily due to timing of orders related to certain military programs.
Cost of Goods Sold
Cost of goods sold decreased by $5.2 million, or 5.6%, to $88.4 million, or 88.7% of net sales, during fiscal 2021, compared with $93.6 million or 82.4% of net sales in the comparable period of fiscal 2020. The decrease was primarily due to lower volume from the commercial aerospace programs, cost controlling measures and the non-recurrence of the one-time pension withdrawal charge of $0.8 million incurred in the prior year. Prior year results included higher insurance recoveries by $2.5 million related to business interruption and mitigation expense as part of the fire settlement.
Gross Profit
Gross profit decreased by $8.8 million, or 43.9%, to $11.2 million during fiscal 2021, compared with $20.0 million in fiscal 2020. Gross margin percent of sales was 11.3% during fiscal 2021, compared with 17.6% in fiscal 2020, primarily due to lower volume, higher idle expense costs of $1.9 million and lower insurance recoveries of $0.5 million in fiscal 2021 compared with $2.0 million in the prior year.
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Selling, General and Administrative Expenses
Selling, general and administrative expenses were $13.5 million, or 13.5% of net sales, during fiscal 2021, compared with $14.0 million, or 12.4% of net sales, in 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, such as lower wages related to a furlough at one location and fewer travel expenses, partially offset by higher legal and professional costs and commissions.
Amortization of Intangibles
Amortization of intangibles decreased $0.5 million to $1.0 million during fiscal 2021, compared with $1.5 million in the comparable period of fiscal 2020. Such decrease was primarily due to certain intangible assets that were fully amortized during fiscal 2020.
Other/General
The Company recorded operating loss of $1.1 million during fiscal 2021, compared with an operating income of $10.1 million in fiscal 2020.
Current period results include a gain on insurance recoveries of $2.4 million in fiscal 2021 compared to $5.9 million in fiscal 2020 as it relates to fire claim at the Orange location.
Interest expense decreased $0.3 million to $0.6 million in fiscal 2021, compared with $0.9 million in the same period in fiscal 2020. The decrease is primarily due to the reduction of interest rates and lower average borrowings. See Note 5, Debt, of the consolidated financial statements for further information.
The following table sets forth the weighted average interest rates and weighted average outstanding balances under the Company’s debt agreements in fiscal 2021 and 2020:
Weighted Average
Interest Rate
Years Ended September 30, Weighted Average
Outstanding Balance
Years Ended September 30,
2021 2020 2021 2020
Revolving credit agreement 1.5% 2.9% $ 9.1 million $ 13.8 million
Foreign term debt 3.5% 4.4% $ 7.0 million $ 5.5 million
Other debt 0.9% 0.5% $ 5.7 million $ 6.1 million
The Company believes that inflation did not materially affect its results of operations in either fiscal 2021 or 2020 and does not expect inflation to be a significant factor in fiscal 2022, due to the average duration of our projects. However, no assurances can be made that the Company will not experience inflationary pressures in the future.
Income Taxes
The Company’s effective tax rate in fiscal 2021 was 62.2% compared with (2.3%) in fiscal 2020. The increase in the effective tax rate in fiscal 2021 is primarily attributable to tax benefits from adjusting deferred taxes recorded in Italy applied against a year-to-date loss in fiscal 2021 and changes in jurisdictional mix of income in fiscal 2021 compared with the same period in 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 loss was $0.7 million during fiscal 2021, compared with net income of $9.2 million in fiscal 2020. The decrease in income in the current period was primarily due to lower volume, lower insurance recoveries and higher idle expense, partially offset by continued costs savings activities and the favorable tax benefit recorded in fiscal 2021.
Non-GAAP Financial Measures
Presented below is certain financial information based on our EBITDA and Adjusted EBITDA. References to “EBITDA” mean earnings (losses) from 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.
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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 it 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 profit (loss), to measure operating performance. The Company’s calculation of EBITDA and Adjusted EBITDA may not be comparable to the calculation of similarly titled measures reported by other companies.
The following table sets forth a reconciliation of net loss to EBITDA and Adjusted EBITDA:
(Dollars in thousands) Years Ended
September 30,
2021 2020
Net income (loss) $ (743) $ 9,191
Adjustments:
Depreciation and amortization expense 7,662 7,380
Interest expense, net 638 886
Income tax benefit (1,222) (211)
EBITDA 6,335 17,246
Adjustments:
Foreign currency exchange loss, net (1) 23 51
Other income, net (2) (72) (13)
Loss on disposal of assets (3) 209 174
Gain on insurance recoveries (4) (2,397) (5,874)
Equity compensation expense (5) 469 398
Pension settlement/curtailment benefit (6) 274 239
LIFO impact (7) 924 (10)
Adjusted EBITDA $ 5,765 $ 12,211
(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, grant income or extinguishment of debt. Pension settlement costs was reclassed from this line to Pension settlement/curtailment benefit. See Footnote 6.
(3) Represents the difference between the proceeds from the sale of operating equipment and the carrying values shown on the Company’s books or asset impairment of long-lived assets.
(4) 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.
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(5) Represents the equity-based compensation expense recognized by the Company under its 2016 Long-Term Incentive Plan (as the amendment and restatement of, and successor to, the 2007 Long-Term Incentive Plan, and referred to as the "2016 Plan") due to granting of awards, awards not vesting and/or forfeitures.
(6) Represents expense incurred by its defined benefit pension plans related to settlement of pension obligations.
(7) Represents the change in the reserve for inventories for which cost is determined using the last in, first out ("LIFO") method.
Reference to the above activities can be found in the consolidated financial statements included in Item 8 of this Annual Report on Form 10-K.
B. Liquidity and Capital Resources
Historically, the main sources of liquidity of the Company have been cash flows from operations and borrowings under our Credit Agreement (as defined below under "Financing Activities"). The ongoing impact and magnitude of the COVID-19 pandemic remain uncertain (including the pandemic's continued effects on the global economy and potential for market disruptions) with the commercial aerospace industry. Along with the global disruption in travel and, further, the pandemic and responses to the various resurgences and continued spread of the pandemic continue to cause 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 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 management will continue to assess and actively manage liquidity. See "Results of Operation - COVID-19" for further discussion on the impact of the pandemic.
Cash and cash equivalents decreased to $0.3 million at September 30, 2021 compared with $0.4 million at September 30, 2020. At September 30, 2021 and 2020, a nominal amount and $0.4 million, respectively, 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 $3.9 million of cash in fiscal 2021, compared with $0.4 million in fiscal 2020. The cash provided by operating activities in fiscal 2021 was primarily due to non-cash items, such as depreciation and amortization of $7.7 million, LIFO effect of $0.9 million, equity based compensation, and source of working capital of $1.1 million, partially offset by a net gain on insurance recovery combined with loss on disposal of assets of $2.2 million and deferred income taxes of $1.3 million and net loss of $0.7 million. The source of cash from working capital of $1.1 million was primarily due to reductions in receivables due to lower sales and improved collections as well as decreases in inventories, partially offset by payments to suppliers and disbursements related to the fire recovery.
The Company’s operating activities provided $0.4 million of cash in fiscal 2020. The cash provided by operating activities in fiscal 2020 was primarily due to non-cash items, such as depreciation and amortization of $7.4 million, equity based compensation, deferred income taxes and LIFO effect, partially offset by a net gain on insurance recovery combined with loss on disposal of asset of $5.7 million and use of working capital of $10.5 million and net income of $9.1 million. The decrease in cash from operating activities was primarily due to increased inventories and payments to suppliers and disbursements related to the fire recovery.
Investing Activities
Cash used for investing activities was $0.9 million in fiscal 2021, compared with cash used for investing activities of $1.2 million in fiscal 2020. Fiscal 2021 includes $4.1 million in proceeds received from insurance recovery on the damaged property related to the fire at the Orange location, compared with $7.8 million in proceeds received in the previous year. Capital expenditures were $5.0 million, mainly funded by insurance proceeds from the fire in fiscal 2021 and $9.0 million in fiscal 2020. Expenditures in fiscal 2021 and in 2020 were used primarily for the restoration of the Orange location as a result of the fire, which was completed as of September 30, 2021. Capital commitments at September 30, 2021 were $0.8 million. The Company anticipates the total fiscal 2022 capital expenditures will be within the range of $2.5 million to $4.0 million and will relate principally to the further enhancement of production and product offering capabilities and operating cost reductions.
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Financing Activities
Cash used by financing activities was $3.1 million in fiscal 2021 compared to cash provided by financing activities of $0.8 million in fiscal 2020.
As discussed in Note 5, Debt, the Company amended the Credit Agreement and the Export Agreement on February 19, 2021. The combined maximum borrowings remain unchanged at $35.0 million. The Fifth Amendment (the "Fifth Amendment") to the Credit Agreement (as amended, the "Credit Agreement") consists of a senior secured revolving credit facility with a maximum borrowing of $28.0 million, previously $30.0 million. The revolving commitment through the First Amendment (the "First Amendment") of the Export Credit Agreement, which lends amounts to the Company on foreign receivables increased its revolving commitment from $5.0 million to $7.0 million. The Fifth Amendment, among other things, extends the maturity date from August 6, 2021 to February 19, 2024.
As discussed in Note 5, Debt, the Company's Maniago, Italy location obtained borrowings from two separate lenders during fiscal 2021. The first loan was for $0.7 million with repayment terms of 78 months, of which $0.3 million was forgiven in the same period and included as a gain in debt extinguishment in the operating activities within the consolidated statements of cash flows. A second loan with a five year term was obtained in the amount of $0.3 million. The proceeds of these loans were used for working capital purposes. The Company repaid $0.4 million of its Company's foreign term loans in 2021.
In the prior year, the Company received cash proceeds of $6.6 million, which $5.0 million relates to the PPP loan and $1.5 million from a new loan related to the Maniago location. A small portion of the PPP loan was repaid. A total of $1.3 million in cash was used to repay the Company's foreign term loans.
The Company had net repayments under its revolving credit facility of $3.9 million in fiscal 2021 and $2.7 million in fiscal 2020.
Amounts borrowed under the Credit Agreement are secured by substantially all the assets of the Company and its U.S. subsidiaries and a pledge of 66.67% of the stock of its first-tier non-U.S. subsidiaries. Borrowings will bear interest at the lender's established domestic rate or LIBOR, plus the applicable margin as set forth in the Credit Agreement. The revolver has a rate based on LIBOR plus a 1.75% spread, which was 1.8% at September 30, 2021 and the Export Credit Agreement, as discussed in Note 5, Debt, of the consolidated financial statements, has a rate based on LIBOR plus a 1.25% spread, which was 1.3% at September 30, 2021. The Company also has a commitment fee of 0.25% under the Credit Agreement to be incurred on the unused balance of the revolver.
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.
Under the Company's Credit Agreement, the Company is subject to certain customary loan covenants regarding availability as discussed in Note 5, Debt, of the consolidated financial statements. The availability at September 30, 2021 was $14.6 million. If the 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 10.0% of the Revolving Commitment as of September 30, 2021, the FCCR calculation was not required.
The Company incurred debt issuance costs related to the above Credit Agreements and amendments in fiscal 2021. See Note 5, Debt , of the consolidated financial statements for further discussion.
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 along with obtaining new financing in the current year to provide Maniago with sufficient liquidity.
Additionally, the credit and capital markets saw significant volatility during the course of the pandemic. 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
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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.
C. Off-Balance Sheet Arrangements
In the normal course of business, the Company may be party to certain arrangements that are not reflected in the Consolidated Balance Sheets. The Company does not have obligations that meet the definition of an off-balance sheet arrangement that have had, or are reasonably likely to have, a material effect on the Company’s financial condition or results of operations.
D. Critical Accounting Policies and Estimates
Allowances for Doubtful Accounts
The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of certain customers to make required payments. The Company evaluates the adequacy of its allowances for doubtful accounts each quarter based on the customers’ credit-worthiness, current economic trends or market conditions, past collection history, aging of outstanding accounts receivable and specific identified risks. As these factors change, the Company’s allowances for doubtful accounts may change in subsequent periods. Historically, losses have been within management’s expectations and have not been significant.
Inventories
The Company maintains allowances for obsolete and excess inventory. The Company evaluates its allowances for obsolete and excess inventory each quarter. The Company maintains a formal policy, which requires at a minimum, that a reserve be established based on an analysis of the age of the inventory. In addition, if the Company learns of specific obsolescence, other than that identified by the aging criteria, an additional reserve will be recognized. Specific obsolescence may arise due to a technological or market change or based on cancellation of an order. Management’s judgment is necessary in determining the realizable value of these products to arrive at the proper allowance for obsolete and excess inventory.
Revenue Recognition
The Company recognizes revenue using the five-step revenue recognition model in which it depicts the transfer of goods to customers in an amount that reflects the consideration to which a company expects to be entitled in exchange for those goods or services. The revenue standard also requires disclosure sufficient to enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers, including qualitative and quantitative disclosures about contracts with customers, significant judgments and changes in judgments and assets recognized from the cost to obtain or fulfill a contract.
The Company recognizes revenue in the following manner using the five-step revenue recognition model. A contract exists when there is approval and commitment from both parties, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable.
Revenue is recognized when performance obligations under the terms of the contract with a customer of the Company are satisfied. A portion of the Company's contracts are from purchase orders ("PO's"), which continue to be recognized as of a point in time when products are shipped from the Company's manufacturing facilities or at a later time when control of the products transfers to the customer. Under the revenue standard, the Company recognizes certain revenue over time as it satisfies the performance obligations because the conditions of transfer of control to the applicable customer are as follows:
• Certain military contracts, which relate to the provisions of specialized or unique goods to the U.S. government with no alternative use, include provisions within the contract that are subject to the Federal Acquisition Regulation ("FAR"). The FAR provision allows the customer to unilaterally terminate the contract for convenience and requires the customer to pay the Company for costs incurred plus reasonable profit margin and take control of any work in process.
• For certain commercial contracts involving customer-specific products with no alternative use, the contract may fall under the FAR clause provisions noted above for military contracts or may include certain provisions within their contract that the customer controls the work in process based on contractual termination clauses or restrictions of the Company's use of the product and the Company possesses a right to payment for work performed to date plus reasonable profit margin.
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As a result of control transferring over time for these products, revenue is recognized based on progress toward completion of the performance obligation. The selection of the method to measure progress towards completion requires judgment and is based on the nature of the products to be provided. The Company elected to use the cost to cost input method of progress based on costs incurred for these contracts because it best depicts the transfer of goods to the customer based on incurring costs on the contracts. Under this method, the extent of progress towards completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. Revenues are recorded proportionally as costs are incurred.
Revenue is measured as the amount of consideration the Company expects to receive in exchange for transferring goods. An accounting policy election to exclude from transaction price was made for sales, value add, and other taxes the Company collects concurrent with revenue-producing activities when applicable. The Company has elected to recognize incremental costs incurred to obtain contracts, which primarily represent commissions paid to third party sales agents where the amortization period would be less than one year, as selling, general and administrative expenses in the consolidated statements of operations as incurred.
The Company elected a practical expedient under Accounting Standard Codification ("ASC") 606 ("Topic 606") to not adjust the promised amount of consideration for the effects of any significant financing component where the Company expects, at contract inception, that the period between when the Company transfers a promised good to a customer and when the customer pays for that good will be one year or less. Finally, the Company's policy is to exclude performance obligations resulting from contracts with a duration of one year or less from its disclosures related to remaining performance obligations.
The amount of consideration to which the Company expects to be entitled in exchange for the goods is not generally subject to significant variations.
The Company elected to recognize the cost of freight and shipping when control of the products has transferred to the customer as an expense in cost of goods sold on the consolidated statements of operations, because those are costs incurred to fulfill the promise recognized, not a separate performance obligation. To the extent certain freight and shipping fees are charged to customers, the Company recognizes the amounts charged to customers as revenues and the related costs as an expense in cost of goods sold when control of the related products has transferred to the customer.
Contracts are occasionally modified to account for changes in contract specifications, requirements, and pricing. The Company considers contract modifications to exist when the modification either creates new or changes the existing enforceable rights and obligations. Substantially all of the Company's contract modifications are for goods that are distinct from the existing contract. Therefore, the effect of a contract modification on the transaction price and the Company's measure of progress for the performance obligation to which it relates is generally recognized on a prospective basis.
Contract Balances
Contract assets on the consolidated balance sheets are recognized when a good is transferred to the customer and the Company does not have the contractual right to bill for the related performance obligations. In these instances, revenue recognized exceeds the amount billed to the customer and the right to payment is not solely subject to the passage of time. Amounts do not exceed their net realizable value. Contract liabilities relate to payments received in advance of the satisfaction of performance under the contract. Payment from customers are received based on the terms established in the contract with the customer.
Impairment of Long-Lived Assets
The Company reviews the carrying value of its long-lived assets, including property, plant and equipment, when events and circumstances warrant such a review. This review involves judgment and is performed using estimates of future undiscounted cash flows, which include proceeds from disposal of assets and which the Company considers a critical accounting estimate. If the carrying value of a long-lived asset is greater than the estimated undiscounted future cash flows, then the long-lived asset is evaluated for impairment. The Company would assess the fair value of the asset group and compare it to its carrying value. The long-lived assets are considered impaired if the carrying value of the long-lived assets exceeds its fair value, in which case an impairment charge is recorded for the amount by which the carrying value of the long-lived asset exceeds its fair value.
In projecting future undiscounted cash flows, the Company relies on internal budgets and forecasts, and projected proceeds upon disposal of long-lived assets. The Company’s budgets and forecasts are based on historical results and anticipated future market conditions, such as the general business climate and the effectiveness of competition. The Company believes that its estimates of future undiscounted cash flows and fair value are reasonable; however, changes in estimates of such undiscounted cash flows and fair value could change the Company’s estimates, which could result in future impairment charges.
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Impairment of Goodwill
Goodwill is tested for impairment annually as of July 31. If circumstances change during interim periods between annual tests that would more likely than not reduce the fair value of a reporting unit below its carrying value, the Company will test goodwill for impairment. Factors that would necessitate an interim goodwill impairment assessment include a sustained decline in the Company's stock price, prolonged negative industry or economic trends, or significant under-performance relative to expected, historical or projected future operating results. Management uses judgment to determine whether to use a qualitative analysis or a quantitative fair value measurement for its goodwill impairment testing. The Company's fair value measurement approach combines the income and market valuation techniques for each of the Company’s reporting units that carry goodwill. These valuation techniques use estimates and assumptions including, but not limited to, the determination of appropriate market comparables, projected future cash flows (including timing and profitability), discount rate reflecting the risk inherent in future cash flows, perpetual growth rate, and projected future economic and market conditions.
As permitted, if the reporting unit fails the impairment test, the Financial Accounting Standards Board ("FASB") issued an Accounting Standard Update ("ASU") removing step two from the goodwill impairment test. If a reporting unit fails the quantitative impairment test, impairment expense is immediately recorded as the difference between the reporting unit's fair value and carrying value. The Company adopted this standard effective March 31, 2017.
2021 Annual Goodwill Impairment Tests
SIFCO performed its annual test as of July 31, 2021. Goodwill existed at one of the Company's reporting units, Cleveland, Ohio as of September 30, 2021. No impairment charge was identified in connection with the annual goodwill impairment test with respect to the Cleveland reporting unit. Refer to Note 3, Goodwill and Intangible Assets, of the consolidated financial statements for further details.
2020 Annual Goodwill Impairment Tests
SIFCO performed its annual test as of July 31, 2020. Goodwill existed at one of the Company's reporting units, Cleveland, Ohio as of September 30, 2020. No impairment charge was identified in connection with the annual goodwill impairment test with respect to the Cleveland reporting unit. Refer to Note 3, Goodwill and Intangible Assets, of the consolidated financial statements for further details.
Defined Benefit Pension Plan Expense
The Company maintains three defined benefit pension plans in accordance with the requirements of the Employee Retirement Income Security Act of 1974 (“ERISA”). The amounts recognized in the consolidated financial statements for pension benefits under these three defined benefit pension plans are determined on an actuarial basis utilizing various assumptions. The following table illustrates the sensitivity to change in the assumed discount rate and expected long-rate of return on assets for the Company's pension plans as of September 30, 2021.
Impact on Fiscal 2021 Benefits Expense Impact on September 30, 2021 Projected Benefit Obligation for Pension Plans
Change in Assumptions
(In thousands)
25 basis point decrease in discount rate $ 22 $ 790
25 basis point increase in discount rate $ (22) $ (790)
100 basis point decrease in expected long-term rate of return on assets $ 204 $ —
100 basis point increase in expected long-term rate of return on assets $ (204) $ —
The discussion that follows provides information on the significant assumptions/elements associated with these defined benefit pension plans.
The Company determines the expected return on plan assets principally based on (i) the expected return for the various asset classes in the respective plans’ investment portfolios and (ii) the targeted allocation of the respective plans’ assets. The expected return on plan assets is developed using historical asset return performance as well as current and anticipated market conditions such as inflation, interest rates and market performance. Should the actual rate of return differ materially from the assumed/expected rate, the Company could experience a material adverse effect on the funded status of its plans and, accordingly, on its related future net pension expense.
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The discount rate for each plan is determined, as of the fiscal year end measurement date, using prevailing market spot-rates (from an appropriate yield curve) with maturities corresponding to the expected timing/date of the future defined benefit payment amounts for each of the respective plans. Such corresponding spot-rates are used to discount future years’ projected defined benefit payment amounts back to the fiscal year end measurement date as a present value. A composite discount rate is then developed for each plan by determining the single rate of discount that will produce the same present value as that obtained by applying the annual spot-rates. The discount rate may be further revised if the market environment indicates that the above methodology generates a discount rate that does not accurately reflect the prevailing interest rates as of the fiscal year end measurement date. The Company computes a weighted-average discount rate taking into account anticipated plan payments and the associated interest rates from the Findley Pension Discount Curve.
As of September 30, 2021 and 2020, SIFCO used the following assumptions:
Years Ended
September 30,
2021 2020
Discount rate for expenses 3.1 % 2.9 %
Expected return on assets 7.0 % 7.2 %
Deferred Tax Valuation Allowance
The Company accounts for deferred taxes in accordance with the provisions of the Accounting Standards Codification guidance related to accounting for income taxes, whereby the Company recognizes an income tax benefit related to income tax credits, loss carryforwards and deductible temporary differences between financial reporting basis and tax reporting basis.
A high degree of judgment is required to determine the extent a valuation allowance should be provided against deferred tax assets. On a quarterly basis, the Company assesses the likelihood of realization of its deferred tax assets considering all available evidence, both positive and negative. In determining whether a valuation allowance is warranted, the Company evaluates factors such as prior earnings history, expected future earnings, carry-back and carry-forward periods and tax strategies that could potentially enhance the likelihood of the realization of a deferred tax asset. The weight given to the positive and negative evidence is commensurate with the extent to which the evidence may be objectively verified. It is generally difficult to outweigh objectively verifiable negative evidence of recent financial reporting losses. Based on the weight of available evidence, the Company determines if it is more likely than not that its deferred tax assets will be realized in the future.
As a result of losses incurred in recent years, the Company entered into a three-year cumulative loss position in the U.S. jurisdiction during the fourth quarter of fiscal 2016 and remains in a cumulative loss position at the conclusion of fiscal 2021. Accordingly, the Company maintained its valuation allowance on its U.S. deferred tax assets as of the fourth quarter of fiscal year 2021.
Uncertain Tax Positions
The calculation of the Company's tax liabilities also involves considering uncertainties in the application of complex tax regulations. SIFCO recognizes liabilities for uncertain income tax positions based on its estimate of whether it is more likely than not that additional taxes will be required, and it reports related interest and penalties as income taxes. Refer to Note 7, Income Taxes, of the consolidated financial statements.
E. Impact of Newly 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 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 qualify as a
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smaller reporting company ("SRC"), as defined by the Securities and Exchange Commission, to fiscal years 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 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 for the Company beginning October 1, 2021. The effect of adopting this ASU is not expected to have a material impact to the Company's results within the consolidated statements of operations and financial condition.
In March 2020, the FASB issued ASU 2020-04, "Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting," which is intended to provide temporary optional expedients and exceptions to the U.S. GAAP guidance on contract modifications and hedge accounting to ease the financial reporting burden related to the expected market transition from the London Interbank Offered Rate ("LIBOR") and other interbank offered rates to alternative reference rates. This ASU, along with recently issued ASU 2021-01, which further clarifies the scope of Topic 848, is available immediately and may be implemented in any period prior to the guidance expiration on December 31, 2022. ASU 2020-04 was effective beginning on March 12, 2020, and the Company may elect to apply the amendments prospectively through December 31, 2022. The Company has not applied any optional expedients and exceptions to date, and will continue to evaluate the impact of the guidance and whether it will apply the optional expedients and exceptions.
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