TWIN DISC INC 10-K

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Special Note Regarding Smaller Reporting Company Status Under SEC Release 33-10513; 34-83550, Amendments to Smaller Reporting Company Definition, the Company qualifies as a smaller reporting company based on its public float as of the last business day of the second quarter of fiscal 2020. Accordingly, it has scaled some of its disclosures of financial and non-financial information in this annual report. The Company will continue to determine whether to provide additional scaled disclosures of financial or non-financial information in future quarterly reports, annual reports and/or proxy statements if it remains a smaller reporting company under SEC rules. Note on Forward-Looking Statements Statements in this report (including but not limited to certain statements in Items 1, 3 and 7) and in other Company communications that are not historical facts are forward-looking statements, which are based on management’s current expectations. These statements involve risks and uncertainties that could cause actual results to differ materially from what appears here. Forward-looking statements include the Company’s description of plans and objectives for future operations and assumptions behind those plans. The words “anticipates,” “believes,” “intends,” “estimates,” and “expects,” or similar anticipatory expressions, usually identify forward-looking statements. In addition, goals established by the Company should not be viewed as guarantees or promises of future performance. There can be no assurance the Company will be successful in achieving its goals. In addition to the assumptions and information referred to specifically in the forward-looking statements, other factors, including, but not limited to those factors discussed under Item 1A, Risk Factors, could cause actual results to be materially different from what is presented in any forward-looking statements. As discussed in Item 1A, Risk Factors, and Note A, Basis of Presentation and Significant Accounting Policies of the notes to the consolidated financial statements, as a result of the COVID-19 outbreak, the Company’s operations have decreased, starting on or around mid-March 2020, on a staggered basis, to curtail the spread of the virus and in compliance with regulatory authorities. The Company’s plants and offices around the world have been subject to intermittent shutdowns, impacting the timeliness of supply chain arrangements and product shipments. The COVID-19 outbreak exacerbates an already depressed global oil and gas market, which has recently been severely damaged by unprecedented drastic declines in the price of oil. The consensus of experts is that the price of oil was driven down by an oversupply in the global market, and aggravated by the price war among members of OPEC and non-OPEC producer nations. The COVID-19 outbreak, and its impact on consumption behaviors and expected general market contraction, impacts the future demand for oil, and exacerbates the already challenging market conditions. 14 The Company has already seen the impact of the depressed global energy market on its operations. Its North American incoming orders for the fiscal 2020 fourth quarter were down approximately 50% from the fiscal year-to-date run rate through the third fiscal quarter. As described further in Note E, Goodwill and Other Intangibles, the Company recorded significant non-cash impairment charges during the year. While the Company continues to have a positive outlook of its operations in Europe, both in the European Propulsion and European Industrial reporting units, and remains committed to supporting those operations, the adverse economic effects of the COVID-19 outbreak are not fully known. However, there is consensus that the impact will be adverse. Hence, management has modeled those expectations from industry and subject matter experts and determined that prudence in the face of uncertainty warrants a robust scenario modeling approach. This approach was deployed in the Company’s goodwill and long-lived asset impairment analyses. In assessing the current environment, management expects that a contraction of the global economy, as is predicted by many experts, would reduce or shift the demand for its products in the near term. For example, the Company expects that the demand for certain of the reporting units’ end-market products, such as passenger leisure cruise vessels, passenger ferries, and other commercial vessels that operate based on general economic activities, will likely be adversely impacted as social restrictions are put in place by governments to curb the outbreak. As a consequence of these macroeconomic developments, market insights and expectations, the Company recorded asset impairment charges in the third fiscal quarter, primarily consisting of goodwill and other intangibles, in the amount of $27,603. The full impact of the COVID-19 outbreak continues to evolve as of the date of this report. The depth and duration of the economic effects caused by the outbreak are unknown. Management is actively monitoring the global situation and its effect on its financial condition, liquidity, operations, suppliers, industry, and workforce. Some of the initiatives undertaken so far include: ● Protecting the welfare of our employees worldwide by implementing remote work arrangements, temporarily closing or suspending plants and offices, enhancing safety protocols to those employees who cannot work from home; ● Availing of programs made available by the various countries through government-sponsored programs, such as emergency liquidity credit facilities, enhanced unemployment compensation benefits and furlough arrangements; ● Working with customers to address the timing of customer orders and payment needs during the crisis; ● Implementing wage reduction actions, curtailing non-critical capital expenditures, and other cost reduction and cash preservation actions; ● Maintaining effective governance and internal controls in a remote environment. The Company continues to evaluate all possible avenues to reduce costs and improve liquidity in light of the unprecedented uncertainty in the global economy. The following discussion of results of operations reflects actual Company performance through June 30, 2020. They do not include management’s view of future performance as the COVID-19 impacts, as severe as they are expected to be, are difficult to predict with specificity. 15 Results of Operations (In thousands) % of % of 2020 Sales 2019 Sales Net sales $ 246,838 $ 302,663 Cost of goods sold 191,130 213,022 Gross profit 55,708 22.6 89,641 29.6 Marketing, engineering and administrative expenses 63,218 25.6 71,541 23.6 Restructuring expenses 5,138 2.1 1,179 0.4 Goodwill and other asset impairment charge 27,603 11.2 - - Other operating income - - (1,577 ) (0.5 ) (Loss) income from operations $ (40,251 ) (16.3 ) $ 18,498 6.1 Fiscal 2020 Compared to Fiscal 2019 Net Sales Net sales for fiscal 2020 decreased 18.4%, or $55.8 million, to $246.8 million from $302.7 million in fiscal 2019. The Company experienced weakness in North American demand for the Company’s oil and gas related products, with a decline of approximately $49.7 million compared to the prior year. This weakness was a function of a cyclical downturn that began at the end of fiscal 2019, exacerbated by an oil price war between Russia and Saudi Arabi in the third quarter of fiscal 2020, and the significant decline in global demand for oil as a result of the COVID-19 pandemic. Similarly, the remaining decline in the Company’s global industrial markets can be attributed primarily to global economic weakness during the second half of the fiscal year, brought on by the COVID-19 pandemic. Currency translation had a $4.8 million unfavorable impact on fiscal 2020 sales. Sales at our manufacturing segment decreased 18.9%, or $52.9 million, versus the same period last year. The largest decline was seen at the Company’s North American manufacturing operation, the largest, which experienced a 27.4% decline in sales compared to fiscal 2019. The primary driver for this decrease was reduced demand for the Company’s oil and gas related products, primarily new and replacement units, throughout the fiscal year. This operation also experienced a general decline across its product lines as a result of the global economic impact of the COVID-19 pandemic. The Company’s Veth Propulsion operation in the Netherlands generated a 6.2% increase in sales in fiscal 2020, offsetting the impact of the weakening global economy with improved market penetration and acceptance in their non-traditional markets (Asia and North America). The Company’s Italian manufacturing operations were essentially flat for the year, as a weaker fourth quarter offset some improvement through the first three fiscal quarters. The Company’s Belgian manufacturing operation saw a 27.8% decrease in sales in fiscal 2020 on weaker demand in the marine markets served by this operation resulting from the COVID-19 impact, along with a currency impact. The Company’s Swiss manufacturing operation, which supplies customized propellers for the global mega yacht and patrol boat markets, experienced a 25.9% decrease in sales, also due to generally weaker economic conditions. Sales at our distribution segment were down 10.0%, or $10.7 million, compared to fiscal 2019. The Company’s Asian distribution operation in Singapore, China and Japan experienced a 2.6% increase in sales due to a strong demand for the Company’s oil and gas transmissions, partially offset by a weakening Asian economy primarily in the fourth fiscal quarter. The Company’s distribution operation in the Northwest of the United States and Southwest of Canada experienced a decrease in sales of $13.2 million as this business was sold in early March 2019. The Company’s European distribution operation saw an increase of $2.5 million as this is a new entity established in fiscal 2019 to distribute the Company’s products in the European market. The Company’s North American distribution operation saw a decline of 4.3% on the reduced activity in the North American oil and gas market and a weaker North American economy in the fourth fiscal quarter. The Company’s distribution operation in Australia, which provides boat accessories, propulsion and marine transmission systems primarily for the pleasure craft market, saw sales decline slightly (1.2%), driven by a significant unfavorable currency impact (7.7%). Net sales for the Company’s marine transmission, propulsion and boat management systems were up 1.5% compared to the prior fiscal year. This increase primarily reflects a strong performance from the Veth Propulsion acquisition, which saw sales increase by $3.4 million (6.2%) compared to fiscal 2019. In the off-highway transmission market, the year-over-year decrease of 44.4% can be attributed primarily to decreased shipments of the Company’s pressure pumping transmission systems and components to the North American market driven by the significant decline in global oil prices. The decrease experienced in the Company’s industrial products of 22.3% was seen primarily in the second half of the fiscal year, brought on by a weakening global economy and the impacts of the COVID-19 pandemic. 16 Geographically, sales to the U.S. and Canada declined 38% in fiscal 2020 compared to fiscal 2019, representing 36% of consolidated sales for fiscal 2020 compared to 47% in fiscal 2019. The reduction is primarily due to the reduced shipments of oil and gas related products into North America during the fiscal 2020. Sales into the Asia Pacific market declined 9% compared to fiscal 2019 and represented approximately 21% of sales in fiscal 2020, compared to 18% in fiscal 2019. Sales into the European market improved approximately 8% from fiscal 2019 levels while accounting for 37% of consolidated net sales compared to 28% in fiscal 2019. The increase is primarily the result of the strong performance by the Veth Propulsion acquisition, which has a high percentage of sales into the European market. See Note K, Business Segments and Foreign Operations, of the notes to the consolidated financial statements for more information on the Company’s business segments and foreign operations. Gross Profit In fiscal 2020, gross profit decreased $33.9 million, or 37.9%, to $55.7 million on a sales decrease of $55.8 million. Gross profit as a percentage of sales decreased 700 basis points in fiscal 2020 to 22.6%, compared to 29.6% in fiscal 2019. The table below summarizes the gross profit trend by quarter for fiscal years 2020 and 2019: 1 st Qtr 2 nd Qtr 3 rd Qtr 4 th Qtr Year Gross Profit: ($ millions) 2020 $ 9.6 $ 15.7 $ 16.5 $ 13.9 $ 55.7 2019 $ 24.0 $ 26.1 $ 23.1 $ 16.4 $ 89.6 % of Sales: 2020 16.3 % 26.4 % 24.1 % 23.3 % 22.6 % 2019 32.1 % 33.4 % 29.9 % 22.7 % 29.6 % There were a number of factors that impacted the Company’s overall gross profit rate in fiscal 2020. Gross profit for the year was primarily impacted by reduced volumes and an unfavorable product mix. This was driven by reduced sales of high-margin oil and gas transmissions and parts. Margin was also negatively impacted by a $6.2 million charge for a product performance issue related to one of the Company’s oil and gas transmission models. The Company estimates the net unfavorable impact of reduced volumes on gross profit in fiscal 2020 was approximately $16.5 million. The unfavorable shift in product mix, primarily related to the reduced shipments of the Company’s high margin oil and gas transmission units and aftermarket products, had an estimated unfavorable impact of $15.3 million. Marketing, Engineering and Administrative (ME&A) Expenses Marketing, engineering, and administrative (ME&A) expenses of $63.2 million were down $8.3 million, or 11.6%, compared to the prior fiscal year. As a percentage of sales, ME&A expenses increased to 25.6% of sales versus 23.6% of sales in fiscal 2019. The decrease in spending in fiscal 2020 compared to the prior year was driven by reduced spending on professional fees ($1.9 million), the elimination of the global bonus program for fiscal 2020 ($1.7 million), the impact of the sale of Mill Log in the fiscal 2019 third quarter ($1.8 million), reduced stock based compensation ($0.7 million), lower marketing spending ($0.8 million), reduced corporate travel expense ($0.7 million), a favorable foreign currency impact ($0.9 million) and general cost containment measures ($1.7 million). These decreases were partially offset by an increase to intangible amortization expense ($1.9 million). Restructuring of Operations During the course of fiscal 2020, the Company incurred $5.1 million in restructuring charges. Included in this amount is $3.2 million related to the termination of a marine propulsion program, for which the Company had provided development and production services. The $3.2 million included a $2.2 million non-cash write-off of assets and liabilities associated with the program and $1.0 million of cash payments to satisfy supplier commitments related to the program. The remaining $1.9 million of restructuring charges relates to productivity and cost reduction actions at the Company’s domestic and European operations. The Company continues to focus on actively managing its cost structure and reducing fixed costs in light of the ongoing market challenges. 17 Impairment Charges As described in Note E, Goodwill and Other Intangibles, due to the occurrence of a triggering event in the third fiscal quarter, the Company performed an assessment of its goodwill, intangibles and other long-lived assets as of March 27, 2020. As a result, the Company recorded an impairment charge of $27.6 million during the third quarter of fiscal 2020. This non-cash impairment charge does not result in any future cash expenditures, impact liquidity, affect ongoing business or financial performance of the Company, impact compliance with our lending arrangements or reduce borrowing capacity. Interest Expense Interest expense of $1.9 million for fiscal 2020 was essentially unchanged from the prior fiscal year. Other Income (Expense), Net and Interest Income In fiscal 2020, other expense, net, decreased $0.4 million primarily due to the impact of currency movements related to the euro and Asian currencies. Income Taxes The effective tax rate for the twelve months of fiscal 2020 was 9.5%, which was significantly lower than the prior year rate of 25.6%. Under the Tax Cuts and Jobs Act, a company is prohibited from recognizing certain foreign global intangible low taxed income (“GILTI”) deductions and credits when in a domestic loss position, but is required to include the foreign GILTI income inclusions. In the current year, the benefit generated from domestic losses was reduced by the required GILTI foreign income inclusions and no GILTI deductions. The $5.8 million GILTI inclusion and deemed taxes decreased the rate by 2.8%. Management determined that the carrying value of certain goodwill and intangibles exceeded the fair value and a $27.6 million impairment loss was calculated which resulted in a decrease to the effective tax rate of 10.9%. Income generated in foreign jurisdictions and other tax preference items also impacted the rate. The Company maintains valuation allowances when it is more likely than not that all or a portion of a deferred tax asset will not be realized. Changes in valuation allowances from period to period are included in the tax provision in the period of change. In determining whether a valuation allowance is required, the Company takes into account such factors as prior earnings history, expected future earnings, carry-back and carry-forward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. Management believes that it is more likely than not that the results of future operations will generate sufficient taxable income and foreign source income to realize all of the deferred tax assets. Order Rates As of June 30, 2020, the Company’s backlog of orders scheduled for shipment during the next six months (six-month backlog) was $66.6 million or approximately 33% lower than the six-month backlog of $99.8 million as of June 30, 2019. The reduced backlog is primarily attributable to a lower level of North American oil and gas transmission units on order, along with the global economic weakness resulting from the COVID-19 pandemic and its impact across the Company’s products. 18 Liquidity and Capital Resources Fiscal Years 2020 and 2019 The net cash provided by operating activities in fiscal 2020 totaled $9.1 million, an increase of $14.6 million from the prior fiscal year. While net earnings decreased by $50.4 million from the prior year, a significant portion of this decline related to a $27.6 million non-cash impairment charge. In addition, working capital improved by $20.0 million during the year, with the largest contributions coming from trade receivables ($13.1 million) and inventory ($6.8 million), as the Company focused on working capital management in light of difficult market conditions. The net cash used by investing activities for fiscal 2020 primarily represents capital spending activity totaling $10.7 million. This represents a $1.3 million (10.7%) decrease in spending on capital projects compared to fiscal 2019. The Company continued to invest in critical machine tools with improved technology to increase productivity and quality performance. The net cash used by financing activities relates to payments of withholding taxes on stock compensation ($0.9 million) and dividends paid to a noncontrolling interest ($0.3 million). Total debt remained relatively unchanged compared to the prior year-end. During fiscal 2020, the Company did not purchase any shares as part of its Board-authorized stock repurchase program. The Company has 315,000 shares remaining under its authorized stock repurchase plan. Future Liquidity and Capital Resources On June 29, 2018, the Company entered into the Credit Agreement (the “Credit Agreement”) with BMO Harris Bank N.A. (“BMO”) that provided for the assignment and assumption of the previously existing loans between the Company and Bank of Montreal (the “2016 Credit Agreement”) and subsequent amendments into a term loan (the “Term Loan”) and revolving credit loans (each a “Revolving Loan” and, collectively, the “Revolving Loans,” and, together with the Term Loan, the “Loans”). Pursuant to the Credit Agreement, BMO agreed to make the Term Loan to the Company in a principal amount not to exceed $35.0 million and the Company may, from time to time prior to the maturity date, enter into Revolving Loans in amounts not to exceed, in the aggregate, $50.0 million (the “Revolving Credit Commitment”). The Credit Agreement also allows the Company to obtain Letters of Credit from BMO, which if drawn upon by the beneficiary thereof and paid by BMO, would become Revolving Loans. Under the Credit Agreement, the Company may not pay cash dividends on its common stock in excess of $3.0 million in any fiscal year. On March 4, 2019, the Company entered into a second amendment (the “Second Amendment”) to the Credit Agreement. The Second Amendment reduced the principal amount of the term loan commitment under the Credit Agreement from $35.0 million to $20.0 million. In connection with the Second Amendment, the Company issued an amended and restated term note in the amount of $20.0 million to the Bank, which amended the original $35.0 million note provided under the Credit Agreement. Prior to entering into the Second Amendment, the outstanding principal amount of the term loan (the “Term Loan”) under the Credit Agreement was $10.8 million. On the date of the Second Amendment, the Bank made an additional advance on the Term Loan to the Company in the amount of $9.2 million. The Second Amendment also extended the maturity date of the Term Loan from January 2, 2020 to March 4, 2026, and added a requirement that the Company make principal installments of $0.5 million per quarter starting with the quarter ending June 30, 2019. The Second Amendment also reduced the applicable margin for purposes of determining the interest rate applicable to the Term Loan. Previously, the applicable margin was 3.00%, which was added to the Monthly Reset LIBOR Rate or the Adjusted LIBOR, as applicable. Under the Second Amendment, the applicable margin was between 1.375% and 2.375%, depending on the Company’s total funded debt to EBITDA ratio. The Second Amendment also adjusted certain financial covenants made by the Company under the Credit Agreement. Specifically, the Company covenanted (i) not to allow its total funded debt to EBITDA ratio to be greater than 3.00 to 1.00 (the cap had previously been 3.50 to 1.00 for quarters ending on or before September 30, 2019 and 3.25 to 1.00 for quarters ending on or about December 31, 2019 through September 30, 2020), and (ii) that its tangible net worth will not be less than $100.0 million plus 50% of net income for each fiscal year ending on and after June 30, 2019 for which net income is a positive number (the $100.0 million figure had previously been $70.0 million). On January 28, 2020, the Company entered into a third amendment (the “Third Amendment”) to the Credit Agreement. The Third Amendment restated the financial covenant provisions related to the maximum allowable ratio of total funded debt to EBITDA from 3.00 to 1.00 to 4.00 to 1.00 for the quarter ended December 27, 2019, 5.00 to 1.00 for the quarter ending March 27, 2020, 4.00 to 1.00 for the quarter ending June 30, 2020, 3.50 to 1.00 for the quarter ending September 25, 2020 and 3.00 to 1.00 for quarters ending on or after December 25, 2020. For purposes of determining EBITDA, the Third Amendment added back extraordinary expenses (not to exceed $3.9 million) related to the previously reported isolated product performance issue on one of the Company’s oil and gas transmission models at certain installations. Under the Third Amendment, the applicable margin for revolving loans, letters of credit, and term loans was between 1.25% and 3.375%, depending on the Company’s total funded debt to EBITDA ratio. 19 On July 22 2020, the Company entered into a fifth amendment to the Credit Agreement (the “Fifth Amendment”) that amends the Credit Agreement dated as of June 29, 2018, as amended between the Company and BMO. The Fifth Amendment reduced BMO’s Revolving Credit Commitment from $50.0 million to $45.0 million. The Fifth Amendment also gives the Company the option to make interest-only payments on the Term Loan for quarterly payments occurring on September 30, 2020 and December 31, 2020, and limits the Company’s Capital Expenditures for the fiscal year ending June 30, 2021 to $10.0 million. The Fifth Amendment provides the Company with relief from its Total Funded Debt to EBITDA ratio financial covenant under the Credit Agreement through (and including) the earlier of June 30, 2021 or a date selected by the Company. During the financial covenant relief period: ● The “Applicable Margin” to be applied to Revolving Loans, the Term Loan, and the Commitment/Facility Fee will be increased to 3.25%, 3.875%, and 0.20%, respectively. ● The Company may not make certain restricted payments (specifically, cash dividends, distributions, purchases, redemptions or other acquisitions of or with respect to shares of its common stock or other common equity interests). ● The Company must maintain liquidity (as defined in the Fifth Amendment) of at least $15.0 million. ● The Company must maintain minimum EBITDA of at least (1) $1.0 million for the fiscal quarter ending June 30, 2020 and the two fiscal quarters ending on or about September 30, 2020; (2) $2.5 million for the three fiscal quarters ending on or about December 31, 2020; (3) $6.0 million for the four fiscal quarters ending on or about March 31, 2021; and (4) $10.0 million for the four fiscal quarters ending June 30, 2021. For purposes of the minimum EBITDA covenant and the Total Funded Debt to EBITDA ratio, the Fifth Amendment clarified that EBITDA shall exclude any gain that is realized on the forgiveness of the Small Business Administration Paycheck Protection Program loan that the Company previously received. The Fifth Amendment also changed the definition of “LIBOR” (used in calculating interest on Eurodollar Loans), “Monthly Reset LIBOR Rate” (used in calculating interest on LIBOR Loans), and “LIBOR Quoted Rate” (used in the definition of “Base Rate,” which is used in calculating interest on Letters of Credit that are drawn upon and not timely reimbursed). The Company also entered into a Deposit Account Control Agreement with the Bank, reflecting the Bank’s security interest in deposit accounts the Company maintains with the Bank. Under the Fifth Amendment, the Bank may not provide a notice of exclusive control of a deposit account (thereby obtaining exclusive control of the account) prior to the occurrence or existence of a Default or an Event of Default under the Credit Agreement or otherwise upon the occurrence or existence of an event or condition that would, but for the passage of time or the giving of notice, constitute a Default or an Event of Default under the Credit Agreement. Borrowings under the Credit Agreement are secured by substantially all of the Company’s personal property, including accounts receivable, inventory, machinery and equipment, and intellectual property. The Company has also pledged 100% of its equity interests in certain domestic subsidiaries and 65% of its equity interests in certain foreign subsidiaries. The Company also entered into a Collateral Assignment of Rights under Purchase Agreement for its acquisition of Veth Propulsion. To effect these security interests, the Company entered into various amendment and assignment agreements that consent to the assignment of certain agreements previously entered into between the Company and the Bank of Montreal in connection with the 2016 Credit Agreement. The Company also amended and assigned to BMO a Negative Pledge Agreement that it has previously entered into with Bank of Montreal, pursuant to which it agreed not to sell, lease or otherwise encumber real estate that it owns except as permitted by the Credit Agreement and the Negative Pledge Agreement. Upon the occurrence of an Event of Default, BMO may take the following actions upon written notice to the Company: (1) terminate its remaining obligations under the Credit Agreement; (2) declare all amounts outstanding under the Credit Agreement to be immediately due and payable; and (3) demand the Company to immediately Cash Collateralize L/C Obligations in an amount equal to 105% of the aggregate L/C Obligations or a greater amount if BMO determines a greater amount is necessary. If such Event of Default is due to the Company’s bankruptcy, BMO may take the three actions listed above without notice to the Company. 20 On April 17, 2020, the Company entered into a promissory note (the “PPP Note”) evidencing an unsecured loan in the amount of $8.2 million (the “PPP Loan”) made to the Company under the Paycheck Protection Program (“PPP”). The PPP was established under the CARES Act and is a program under the U.S. Small Business Administration (the “SBA”). The PPP Loan to the Company is administered by BMO. The PPP Loan has a two-year term and bears interest at a rate of 1.0% per annum. Monthly principal and interest payments are deferred for six months. Beginning November 17, 2020, seven months from the date of the PPP Note, the Company is required to make monthly payments of principal and interest to BMO. Under the terms of the CARES Act, PPP loan recipients can be granted forgiveness for all or a portion of loans granted under the PPP. Such forgiveness will be determined, subject to limitations, based on the use of loan proceeds for payment of payroll costs and any payments of mortgage interest, rent, and utilities. The Company intends to use the Loan proceeds in accordance with PPP loan forgiveness requirements. However, no assurance is provided that the Company will obtain forgiveness for any portion of the PPP Loan. In connection with the PPP Loan, the Company entered into a fourth amendment to the Credit Agreement (the “Fourth Amendment”) on April 17, 2020. The Fourth Amendment: (1) permits the Company to incur indebtedness in the form of the PPP Loan notwithstanding the Credit Agreement’s restrictions limiting the Company’s ability to incur indebtedness, and (2) provides that the PPP Loan (to the extent that the PPP Loan is forgiven) shall be disregarded for purposes of calculating financial covenants in the Credit Agreement. Any unforgiven portion of the PPP Loan and the interest thereon will not be disregarded for purposes of calculating the covenants. The Company is closely tracking qualified expenses to ensure its compliance to the PPP program and to support its application for forgiveness. As of June 30, 2020, the Company estimates that the amount of forgivable expenses it has incurred to date is approximately $6.0 million. These expenses are included in cost of goods sold and marketing, engineering and administrative expenses in the accompanying statement of operations and comprehensive (loss) income. While the forgiveness of the loan is not taxable, the expenses that were used by the funds are not deductible for tax purposes. Although the rules are still fluid and subject to revisions, currently the Company expects that at the end of the measurement period, it would be able to provide support and qualify for loan forgiveness in the amount of approximately $7.0 million to $7.6 million. If, and when, forgiveness of this amount is assured, the Company would record this as a gain on debt extinguishment in fiscal 2021. This is described further in Note H, Debt, of the notes to the consolidated financial statements. The Company has no material off-balance-sheet arrangements, and it continues to have sufficient liquidity for near-term needs. The Company had approximately $27.0 million of available borrowings under the Credit Agreement as of June 30, 2020. The Company expects to continue to generate enough cash from operations, as well as its credit facilities, to meet its operating and investing needs. As of June 30, 2020, the Company also had cash of $10.7 million, primarily at its overseas operations. These funds, with some restrictions and tax implications, are available for repatriation as deemed necessary by the Company. In fiscal 2021, the Company expects to contribute $2.3 million to its defined benefit pension plans, the minimum contribution required. Net working capital decreased $20.0 million, or 15.7%, during fiscal 2020 and the current ratio (calculated as total current assets divided by total current liabilities) decreased from 2.7 at June 30, 2019 to 2.6 at June 30, 2020. The decrease in net working capital was primarily driven by volume driven reductions in trade accounts receivable and inventory, along with aggressive management of working capital in light of difficult economic conditions. The Company expects capital expenditures to be approximately $7 million - $9 million in fiscal 2021. These anticipated expenditures reflect the Company’s plans to moderate investment in maintenance capital and modern equipment to address the liquidity demands of an anticipated challenging global economy. Management believes that available cash, the BMO credit facility, cash generated from future operations, and potential access to debt markets will be adequate to fund the Company’s capital requirements for the foreseeable future. 21 Off Balance Sheet Arrangements and Contractual Obligations The Company had no material off-balance sheet arrangements as of June 30, 2020 and 2019. On July 31, 2020, the Company finalized an agreement to lease a manufacturing, assembly and office facility in Lufkin, Texas, with an initial term of 15 years and minimum annual lease payments of $0.4 million. Other Matters Critical Accounting Policies and Estimates The preparation of this Annual Report requires management’s judgment to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. The Company’s significant accounting policies are described in Note A, Basis of Presentation and Significant Accounting Policies, of the notes to the consolidated financial statements. Not all of these significant accounting policies require management to make difficult, subjective, or complex judgments or estimates. However, the policies management considers most critical to understanding and evaluating its reported financial results are the following: Accounts Receivable The Company performs ongoing credit evaluations of its customers and adjusts credit limits based on payment history and the customer’s credit-worthiness as determined by review of current credit information. The Company continuously monitors collections and payments from its customers and maintains a provision for estimated credit losses based upon its historical experience and any specific customer-collection issues. In addition, senior management reviews the accounts receivable aging on a monthly basis to determine if any receivable balances may be uncollectible. Although the Company’s accounts receivable are dispersed among a large customer base, a significant change in the liquidity or financial position of any one of its largest customers could have a material adverse impact on the collectability of its accounts receivable and future operating results. Inventory Inventories are valued at the lower of cost or net realizable value. Cost has been determined by the last-in, first-out (LIFO) method for the majority of the inventories located in the United States, and by the first-in, first-out (FIFO) method for all other inventories. Management specifically identifies obsolete products and analyzes historical usage, forecasted production based on future orders, demand forecasts, and economic trends when evaluating the adequacy of the reserve for excess and obsolete inventory. The adjustments to the reserve are estimates that could vary significantly, either favorably or unfavorably, from the actual requirements if future economic conditions, customer demand or competitive conditions differ from expectations. Goodwill Goodwill is tested for impairment annually or more frequently if events or changes in circumstances indicate that an impairment might exist. The Company performs impairment reviews for its reporting units using a fair-value method based on management’s judgments and assumptions or third party valuations. In determining the fair value of the Company’s reporting units, management is required to make estimates of future operating results, including growth rates, and a weighted-average cost of capital that reflects current market conditions, among others. The development of future operating results incorporates management's best estimates of current and future economic and market conditions which are derived from a review of past results, current results and approved business plans. Many of the factors used in assessing fair value are outside the control of management, and these assumptions and estimates can change in future periods. While the Company believes its judgments and assumptions were reasonable, different assumptions, economic factors and/or market indicators could materially change the estimated fair values of the Company’s reporting units. 22 The following are key assumptions to the Company’s discounted cash flow model: Business Projections – The Company makes assumptions about the level of sales for each fiscal year including expected growth, if any. This assumption drives its planning for volumes, mix, and pricing. The Company also makes assumptions about its cost levels (e.g., capacity utilization, cost performance, etc.). These assumptions are key inputs for developing its cash flow projections. These projections are derived using the Company’s internal business plans that are reviewed during the annual budget process. Discount Rates – When measuring a possible impairment, future cash flows are discounted at a rate that is consistent with a weighted average cost of capital for a potential market participant. The weighted average cost of capital is an estimate of the overall after-tax rate of return required by equity and debt holders of a business enterprise. There are a number of assumptions that management makes when calculating the appropriate discount rate, including the targeted leverage ratio. The Company is subject to financial statement risk to the extent the carrying amount of a reporting unit exceeds its fair value. The Company believes that the economic disruptions and unprecedented market volatilities and uncertainties resulting from the COVID-19 outbreak was a triggering event in the third quarter of fiscal 2020. Consequently, it performed an interim goodwill impairment test as of the quarter ended March 27, 2020, and recorded a goodwill impairment charge of $25.4 million, that completely wrote-off goodwill from its financial statements. See discussion in Note E, Goodwill and Other Intangibles, of the notes to the consolidated financial statements. Long-lived Assets The Company reviews long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. For property, plant and equipment and other long-lived assets, excluding indefinite-lived intangible assets, the Company performs undiscounted operating cash flow analyses to determine if an impairment exists. If an impairment is determined to exist, any related impairment loss is calculated based on fair value. Fair value is primarily determined using discounted cash flow analyses; however, other methods may be used to substantiate the discounted cash flow analyses, including third party valuations when necessary. Warranty The Company engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its suppliers. However, its warranty obligation is affected by product failure rates, the extent of the market affected by the failure and the expense involved in satisfactorily addressing the situation. The warranty reserve is established based on the Company’s best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date. When evaluating the adequacy of the reserve for warranty costs, management takes into consideration the term of the warranty coverage, historical claim rates and costs of repair, knowledge of the type and volume of new products and economic trends. While the Company believes that the warranty reserve is adequate and that the judgment applied is appropriate, such amounts estimated to be due and payable in the future could differ materially from what actually transpires. Pension and Other Postretirement Benefit Plans The Company provides a wide range of benefits to employees and retired employees, including pensions and postretirement health care coverage. Plan assets and obligations are recorded annually based on the Company’s measurement date utilizing various actuarial assumptions such as discount rates, expected return on plan assets, compensation increases, retirement and mortality tables, and health care cost trend rates as of that date. The approach used to determine the annual assumptions are as follows: ● Discount R ate – based on the Willis Towers Watson BOND:Link model at June 30, 2020 as applied to the expected payouts from the pension plans. This yield curve is made up of Corporate Bonds rated AA or better. ● Expected Return on Plan Assets – based on the expected long-term average rate of return on assets in the pension funds, which is reflective of the current and projected asset mix of the funds and considers historical returns earned on the funds. ● Compensation Increase – reflect the long-term actual experience, the near-term outlook and assumed inflation. ● Retirement and Mortality Rates – based upon the Society of Actuaries PRI-2012 base tables for annuitants and non-annuitants, adjusted for generational mortality improvement based on the Society of Actuaries MP-2019 projection scale. ● Health Care Cost Trend Rates – developed based upon historical cost data, near-term outlook and an assessment of likely long-term trends. 23 Measurements of net periodic benefit cost are based on the assumptions used for the previous year-end measurements of assets and obligations. The Company reviews its actuarial assumptions on an annual basis and makes modifications to the assumptions when appropriate. The effects of the modifications are recorded currently or amortized over future periods. Based on information provided by its independent actuaries and other relevant sources, the Company believes that the assumptions used are reasonable; however, changes in these assumptions could impact the Company’s financial position, results of operations or cash flows. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. 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 Company maintains valuation allowances when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In determining whether a valuation allowance is required, the Company takes into account such factors as prior earnings history, expected future earnings, carry-back and carry-forward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. Recently Issued Accounting Standards See Note A, Basis of Presentation and Significant Accounting Policies, of the notes to the consolidated financial statements for a discussion of recently issued accounting standards. Item 7 A . Quantitative and Qualitative Disclosure About Market Risk The Company is electing not to provide this disclosure due to its status as a Smaller Reporting Company. 24