VIRCO MFG CORPORATION 10-K

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Effects of COVID-19 Pandemic The COVID-19 pandemic had an immediate impact on the Company’s operating activities during fiscal 2021, and this impact continued through fiscal 2022. In March 2020, most school districts that we serve closed their doors to students and initiated remote learning. Most school districts in the United States kept campuses closed to students for the remainder of the 2019-2020 academic year, and district business officials typically operated from home offices. During the 2020-2021 academic year many school districts and private schools successfully re-introduced in-class or hybrid learning, but the majority of students in the United States were learning remotely during the Company’s fiscal year ended January 31, 2021. These mass closures impacted more than ten of the twelve months included in this fiscal year, including all of the traditionally busy summer season. The demand for school furniture was adversely impacted by COVID-19 in fiscal year 2021. School administrators were challenged by COVID-19, and purchases of furniture for empty classrooms were not a priority. As a result, order rates declined by approximately 20% compared to the prior year. The Company adopted a number of measures in response to the COVID-19 pandemic. Our sales force worked remotely from March 2020 through January 31, 2021, and as a general matter only physically called on school sites when specifically invited by the district. While students returned to class in many locations, districts continued to limit in person sales calls. Virco determined that the Company is considered to be an essential manufacturer under the California public health order issued in March 2020, and with the exception of a two brief closures of our Torrance operations, all facilities in California and Arkansas have been operating. During the first quarter of fiscal 2022 many schools reopened and virtually all schools were reopened for the beginning of academic year beginning August 2021. The Company received a 26.7% increase in orders in the first quarter of fiscal 2022, substantially all for immediate delivery, to support the back-to-school endeavors. The strong rebound in order rates continued through fiscal 2022 as schools reopened. Order rates for fiscal year 2022 increased by nearly 40% compared to the prior year. Going into fiscal 2022, the Company was cautious about building inventory and began the year with a reduced level of product. The Company was able to support the first quarter increase in orders as the first quarter is a traditionally slow time of the year. The Company experienced severe supply chain issues throughout the rest of the year. The cost and availability of container freight adversely impacted the cost and timely delivery of components imported from China. Domestic suppliers raised prices dramatically, with the cost of steel nearly tripling and the cost of plastic nearly doubling. In addition to increased costs, many domestic suppliers put the Company on allocation as they did not have the production capacity to service all of their customers. 24 When this occurs, the supplier allocates their available capacity to existing customers based upon the customers historic purchase activity. In addition to severe shortages of materials, the Company incurred a severe shortfall of both temporary and full-time labor. This shortfall was exacerbated by COVID-19 related absences that caused as much as 15% of our workforce to be out at any time. In order to meet required levels of production, the Company made a decision to reward our full-time workforce by paying them double-time in lieu of time and one-half for all overtime hours worked. This successfully motivated our employees to work extended hours but cost the Company approximately $2 million. Inability to hire production workers continued through the year, and in October and November the Company significantly increased the starting wages for production workers followed by raises for all hourly workers. With these raises the Company was able to attract and retain additional workers, and as of the date of this report, the Company has an adequate workforce to support anticipated levels of business. Factory efficiencies deteriorated as a result of these events. Rather than execute efficient production runs, factories ran smaller less efficient production runs to utilize whatever materials were available and to fulfill urgent orders. Customers were asked to substitute products requested for products for which materials were available. Labor shortages and absences contributed to the inefficiencies. The cost of materials, unavailability of materials, and labor issues adversely affected gross margins for the year. The education system and education budgets are typically highly dependent on state and local tax revenues. The severity of this pandemic may materially adversely impact state and local tax revenues and result in changes in spending priorities for state and local governments, which may have a material adverse effect on future school budgets. The loss of state and local revenues may be substantially or partially offset by federal programs providing assistance to state governments, local governments and schools, although there can be no assurance that any federal funds could be used for capital expenditures or that the level of federal funding, if any, will be sufficient to maintain our historic order rates for school furniture. Executive Overview of Operating Results The market for school furniture is traditionally seasonal, with approximately 50% of annual sales occurring in the months of June, July, and August. The Company has traditionally met the seasonal needs with significant overtime and by hiring seasonal temporary labor. During fiscal 2021, the demand for school furniture declined primarily due to the COVID-19 pandemic disruption, and the Company reduced production levels. Because of the traditional dependence on temporary seasonal labor, the Company was able to reduce seasonal hiring to match production to demand. The Company did not sever any of its full-time employees during the pandemic. During fiscal 2022 order rates recovered, increasing by nearly 40% compared to fiscal 2021. The Company was unable to hire adequate new permanent workers or temporary labor to meet the traditional summer delivery needs. The markets that Virco serves include the education market (the Company's primary market), which is made up of public and private schools (preschool through 12th grade), junior and community colleges, four-year colleges and universities and trade, technical and vocational schools. Virco also serves convention centers and arenas; the hospitality industry, with respect to their banquet and meeting facilities; government facilities at the federal, state, county and municipal levels; and places of worship. In addition, the Company sells to wholesalers, distributors, retailers, catalog retailers, and internet retailers that serve these same markets. These institutions are frequently characterized by extreme seasonality and/or a bid-based purchasing function. The Company's business model, which is designed to support this strategy, is highly integrated. The Company purchases coils of steel, plastic resin, particle board, and other raw materials and fabricated finished goods for the education market. The Company markets and sells direct to the schools and provides project management and logistics. The Company primarily sells to schools FOB destination, with more than 75% of sales delivered FOB classroom destination. As part of this integrated business model, the Company has developed several competencies to enable superior service to the markets in which Virco competes. An important element of Virco's business model is the Company's emphasis on developing and maintaining key manufacturing, warehousing, distribution, delivery, project management and service capabilities. The Company has developed a comprehensive product offering for the furniture, fixtures and equipment (FF&E) needs of the K-12 education market, enabling a school to procure all of its FF&E requirements from one source. Virco's product offering consists primarily of items manufactured by Virco, complemented with products sourced from other furniture manufacturers to fill any gaps in product manufactured by the Company. The Company has served the education industry for over 72 years and over this time developed products to address a variety classroom management trends, from collaborative learning to individual and combination desks facilitating distancing and classroom control. The pandemic caused a noticeable change in the types of product requested by educators. In fiscal 2021, although total sales were lower than last year, we experienced an increase in the demand for individual desks. Our product offerings are continually enhanced with an ongoing new product development program that incorporates internally developed products as well as product lines developed 25 with accomplished designers. Finally, management continues to hone Virco's ability to forecast, finance, manufacture, warehouse, deliver and install furniture within the relatively narrow delivery window associated with the highly seasonal demand for education sales. The educational sales market is extremely seasonal. Historically Virco ships approximately 50% of its annual revenue in the months of June, July, and August. In fiscal 2022 the seasonal peak was distorted due to severe supply chain interruptions, labor shortages, and COVID-19 related employee absences and the Company delivered slightly less than 40% of sales during June, July, and August. In fiscal 2021, approximately 52% of the Company's total sales were delivered in June, July, and August. The Company anticipates that the traditional seasonal peak will return when COVID and supply chain disruptions normalize. During periods of traditional seasonality, average weekly shipments during July and August can be as great as six times the level of average weekly shipments in the winter months. Virco's substantial warehouse space allows the Company to build and ship adequate inventories to service this narrow delivery window for the education market. The budgetary pressures directly impact the demand for the Company's products, as the demand for educational furniture largely depends upon: (1) available funding in a school's general operating fund and (2) the completion of bond-funded projects, which is directly impacted by the amount of bond financing issued to fund new school construction, to renovate older schools, and to fully equip new and renovated schools. We believe that a significant majority, approximately 80-85%, of a school's operating budget is for the salaries and benefits for school teachers and administrators. Increasing costs for medical insurance, combined with pressures from unfunded post-retirement medical and pension obligations reduces funds available for other purposes. In response to these budgetary pressures, schools typically elect to retain teachers and spend less on repairs, maintenance and replacement furniture, which in turn reduces the demand for, and sales of, the Company's products. Prior to COVID-19, there had been an improvement in state and local tax collections. The long-term impact of COVID-19 combined with potential federal relief is not clear at this time. The significant budgetary challenges faced by the education industry have had an impact on the Company’s business model over this time frame and have created opportunities as well. In response to their budgetary challenges, many school districts closed warehouses and reduced janitorial and support staff in order to retain accredited teachers. Selling efforts must now reach school principals and administrative staff in addition to the district business offices. Sales priced under national contracts or buying groups are displacing competitive bids administered by professional purchasing departments. Distribution has become a more meaningful component of our business as most deliveries are to school sites, and often include delivery into the classroom. This evolution adds to the seasonal challenges of our business, but also creates opportunities to suppliers that can execute during the short summer delivery window. The Company’s operating results can be impacted significantly by cost and volatility of commodities, especially steel, plastic, wood and energy. Because a majority of the Company's sales are generated under annual contracts in which the Company has limited ability to raise the price of its products during the term of the contract, if the costs of the Company's raw materials increase suddenly or unexpectedly, the Company cannot be certain that it will be able to implement immediate corresponding increases in its sales prices in order to offset such increased costs. The Company moderates this exposure by building significant quantities of finished goods and component parts during the first and second quarters. In fiscal 2022, the cost of commodities was extremely volatile and unfavorably impacted the results of operations. The cost of steel nearly tripled and the cost of plastic doubled. Other material costs increased, but not as severely. During fiscal 2021 commodities were reasonably stable. The majority of Virco’s sales include freight to the customer facility and the cost or availability of transportation equipment can adversely impact both profitability and customer service. Significant cost increases in manufacturing or distributing products during a given contract period can adversely impact operating results and have done so during prior years. The Company typically benefits from any decreases in raw material or distribution costs under the contracts described above. During the year ending January 31, 2023 ("fiscal 2023"), the Company anticipates continued uncertainty and volatility in commodity costs, particularly with respect to steel, plastic, and other raw materials, transportation and energy. The global pandemic related to COVID-19 and global sanctions are expected to continue to disrupt global and domestic supply chains. While the Company anticipates challenging economic conditions to continue to impact its core customer base in the near term, there are certain underlying demographics, customer responses and changes in the competitive landscape that provide opportunities. First, the underlying demographics of the student population are stable compared to the volatility of school budgets and the related level of furniture and equipment purchases. This volatility is attributable to the financial health of the 26 school systems. Virco management believes that there is a pent-up demand for quality school furniture (though it is unclear when and to what extent that pent-up demand will be converted into a meaningful increase in purchases). Second, management believes that parents and voters will make quality education an ongoing priority for future government spending. The disruption related to COVID-19 school closures reinforced the need for learning in classroom settings. Third, many schools have responded to the budget strains by reducing their support infrastructure. This change provides opportunities to provide services to schools, such as project management for new or renovated schools, delivery to individual school sites rather than truckload deliveries to central warehouses and delivery of furniture into classrooms. Moreover, this change offers opportunities for Virco to promote its complete product assortment which allows one-stop shopping as opposed to sourcing furniture needs from a variety of suppliers. Fourth, many suppliers previously shut down or dramatically curtailed their domestic manufacturing capabilities, making it difficult for competitors to adapt to dynamic fluctuations in demand or provide custom colors or finishes during a narrow seasonal summer delivery window when they are reliant upon a supply chain extending to Asia or elsewhere. Meanwhile, Virco has continued to invest in automation at its domestic manufacturing facilities, adding flat metal forming processes to its manufacturing capabilities and bringing production into its factories of items formerly sourced from other suppliers (both domestic and international). Domestic production facilitates our product development process, enabling the Company to more rapidly develop new products, release extensions of product families and offer customized variants of our product offering. Virco views its domestic factories as a strategic resource for providing its customers with timely delivery of a broad selection of colors, finishes, laminates, and product styles. Critical Accounting Policies and Estimates This discussion and analysis of Virco's financial condition and results of operations is based upon the Company's consolidated financial statements (“financial statements”), which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires Virco management to make estimates and judgments that affect the Company's reported assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Certain of these estimates are considered critical accounting estimates. On an on-going basis, management evaluates such critical estimates, including those related to valuation of inventory and related excess and obsolescence reserves, self-insured retention for workers' compensation insurance, liabilities under defined benefit and other compensation programs, and estimates related to deferred tax assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. This forms the basis of judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Factors that could cause or contribute to these differences include the factors discussed above under “Item 1, Business” , and elsewhere in this Annual Report on Form 10-K. Virco's critical accounting policies and estimates are as follows: Inventory Valuation : Inventory is valued at the lower of cost or net realizable value (determined on a first-in, first-out basis) and includes material, labor and factory overhead. The Company records valuation adjustments for the excess cost of the inventory over its estimated net realizable value. Valuation adjustments for slow-moving and obsolete inventory are calculated using an estimated percentage applied to inventories based on a physical inspection of the product in connection with a physical inventory, a review of slow-moving products and component stage, inventory category, historical and forecasted consumption of sales, and consideration of active marketing programs. The market for education furniture is traditionally driven by value, not style, and the Company has not typically incurred material obsolescence expenses. If market conditions are less favorable than those anticipated by management, additional valuation adjustments may be required. Due to reductions in sales volume in the past years, the Company's manufacturing facilities are operating at reduced levels of capacity. The Company records the cost of excess capacity as a period expense, not as a component of capitalized inventory valuation. Self-Insured Retention : For fiscal 2022 and 2021 the Company was self-insured for product liability losses up to $250,000 per occurrence, workers' compensation losses up to $250,000 per occurrence, auto and general liability losses up to $50,000 per occurrence. The Company obtains quarterly or semi-annual actuarial valuations for the self-insured retentions. Product liability, workers' compensation and auto reserves for known and unknown incurred but not reported (“IBNR”) losses are recorded at the net present value of the estimated losses using a risk-free discount rate of 4% for fiscal 2022 and 2021. Given the relatively short term over which the known losses and IBNR losses are discounted, the sensitivity to the discount rate is not significant. Estimated workers' compensation losses were funded during the insurance year and subject to retroactive loss adjustments. The Company's exposure to self-insured retentions varies depending upon the market conditions in the insurance industry and the availability of cost-effective insurance coverage. Self-insured retentions for fiscal 2023 will be comparable to the retention levels for fiscal 2022. 27 Defined Benefit Obligations : The Company has two defined benefit plans, the Virco Employees Retirement Plan (“Employee Plan”) and the Virco Important Performers Plan (“VIP Plan”), which provide retirement benefits to employees. Virco discounted the pension obligations for the various plans using the following discount rates for the fiscal years ended January 31: 2022 2021 Employee Plan 3.20% 2.75% VIP Plan 3.20% 2.80% Because new benefit accruals for both plans were frozen by the Company effective December 31, 2003, the assumed rate of increase in compensation has no effect on the accounting for the plans. For the Employee Plan, the Company estimated a 6.0% return on plan assets for 2022 and 6.0% for fiscal 2021. The VIP Plan is unfunded and has no plan assets. These rate assumptions can vary due to changes in interest rates and expected returns in the stock market. In prior years, the discount rate has decreased, causing pension expense and pension obligations to increase. Because the plans have been frozen for many years, there is no service cost related to the plans. In prior years, due to a large number of lump-sum benefits paid to retired and terminated employees, the Company has incurred settlement costs for the Employee Plan. In effort to “de-risk” the Employee Plan, the Company intends to continue to reach out to and offer lump sum benefits to terminated and retired employees, which may result in settlement costs in the future. The Company incurred settlement costs in the second, third, and fourth quarters of fiscal 2022. The Company did not incur settlement costs in fiscal 2021. Due to the size of the Company's pension obligations, a one percent change in discount rates can cause a material change in the pension obligations. A one percent reduction in discount rates would cause obligations under the Plans to increase by approximately $7.6 million and increase pension expense by approximately $801,000. A one percent decrease in return on Plan assets would increase pension expense by $210,000 and have no impact on retirement obligations. The retirement obligations would decrease by similar amounts if discount rate were to increase by a comparable percentage. The Company obtains annual actuarial valuations for both plans. Deferred Tax Assets and Liabilities : In assessing the realizability of deferred tax assets, the Company considers whether it is more-likely-than-not that some portion or all of its deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income or reversal of deferred tax liabilities during the periods in which those temporary differences become deductible. As a part of this evaluation, the Company assesses all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, the availability of tax carry backs, tax-planning strategies, and results of recent operations (including cumulative losses in recent years), to determine whether sufficient future taxable income will be generated to realize existing deferred tax assets. The Company has identified objective and verifiable negative evidence in the form of cumulative losses in the U.S. and in certain state jurisdictions over the preceding twelve quarters ended January 31, 2022. During the fourth quarter of the year ended January 31, 2022, based on this evaluation, and after considering future reversals of existing taxable temporary differences and the effects of seasonality on the Company’s business, the Company determined the realization of a majority of the net deferred tax assets no longer met the more likely than not criteria and a valuation allowance was recorded against the majority of the net deferred tax assets. The amount of the deferred tax asset considered realizable could be adjusted if the Company’s actual results in the future generate taxable income that will allow the Company to utilize its deferred tax assets. The Company’s future taxable income projections are subject to a high degree of uncertainty and could be impacted, both positively and negatively, by changes in our business or the markets in which we operate. A change in the assessment of the realizability of our deferred tax assets could materially impact our results of operations. Results of Operations (fiscal 2022 vs. 2021) Financial Highlights The Company incurred a pre-tax loss of ($3,728,000) on net sales of $184,828,000 for fiscal 2022, compared to pre-tax loss of ($2,976,000) on net sales of $152,795,000 in fiscal 2021. Pre-tax loss deteriorated by $752,000. Net loss per diluted share increased to a loss of ($0.95) for fiscal 2022, compared to a loss of ($0.14) per diluted share in the prior year. Cash flow used in operations was $401,000 in fiscal 2022, compared to cash provided by operations of $7,799,000 in fiscal 2021. Net Sales 28 Virco's net sales increased by 21% in fiscal 2022 to $184,828,000 compared to $152,795,000 in fiscal 2021. The increase in net sales was primarily attributable to an increase in volume in addition to a 5% increase in list selling prices. Virco’s order rates and sales volume have been severely impacted during the last two years by COVID-19, but the impact has been markedly different each year. In fiscal 2021, the Company incurred approximately a 20% reduction in sales orders and sales volume. This reduction was in large part due to the closure of schools throughout the nation. In fiscal year 2022 many schools reopened during the Company’s first quarter, and virtually all schools reopened by the beginning of the Company’s third quarter. During fiscal 2022 order rates increased by approximately 40% compared to the prior year. However, due to severe supply chain issues and labor shortages, we were not able to increase deliveries at the same rate and net sales increased by only 21%. The Company ended the fiscal year with an order backlog that was approximately $20 million higher than the prior year. For fiscal 2023, the COVID-19 pandemic is continuing to create uncertainty as state and local government revenues may be adversely impacted. The potential government revenue shortfall may be offset significantly or in part by a variety of federal government programs. The Company increased selling prices under its largest contracts for orders received after January 1, 2022 to recover volatile and increasing commodity, energy, freight and labor costs. As we have throughout this economic cycle, the Company continues to focus on strategies to develop and strengthen its brand with an aggressive product development campaign. We will continue to use our domestic factories to provide greater flexibility for custom specifications such as laminates, colors and on-time delivery. The Company will continue to emphasize the value, design, variety of its products, the value of its distribution, delivery, classroom delivery and project management capabilities, and the importance of timely deliveries during the peak-seasonal delivery period. To increase or maintain market share during fiscal 2023, when market conditions warrant, the Company may selectively compete based on direct prices to build or maintain its market share. Estimates of sales volume for the next year may continue to be impacted by the COVID-19 pandemic and global events. Demand for project business is anticipated to be stable compared to pre-COVID-19 levels. Short term transactional business increased in fiscal 2022 when schools re-opened and is anticipated to continue. The potential impact of Government stimulus programs and possible failures of competitors cannot be reasonably estimated as of the date of this report. Cost of Sales Cost of sales was 67.0% of net sales in fiscal 2022 and 64.1% of net sales in fiscal 2021. The increase in cost of sales as a percentage of sales was primarily attributable to an increase in the cost and availability of raw materials. The Company incurred severe increases in the cost of steel, plastic, and ocean freight. Other costs increased but not as severely. In addition to increased costs the Company was unable to obtain desired quantities of many materials on a timely basis. Finally, the Company experienced labor shortages, both due to COVID-19 related absences and a lack of available temporary labor. The Company incurred material overtime expenses for its existing employees in effort to meet demand. At the beginning of the fourth quarter, the Company significantly increased the beginning wage rate for all hourly workers and gave meaningful raises to all other hourly workers. This adversely impacted margins in the fourth quarter as selling prices were not increased until January 1, 2022. Direct labor and manufacturing overhead expenses as a percentage of sales were comparable to the prior year, but the Company did not benefit from volume related efficiencies or yield a benefit from the price increase put in place at the beginning of the year. In fiscal 2021, the cost of commodities and labor was reasonably stable. During fiscal 2023, the Company anticipates continued uncertainty and volatility in commodity costs, particularly with respect to certain raw materials, transportation, energy and tariffs due to potential macroeconomic events, including global economic sanctions and the global pandemic caused by COVID-19. The Company also anticipates continued and possibly increased supply chain disruptions from both domestic and international suppliers. Due in part to volatile transportation and energy costs, we may incur higher commodity costs in fiscal 2023. For more information, please see the section below entitled “ Inflation and Future Change in Prices .” Selling, General and Administrative and Other Expenses Selling, general and administrative expenses for fiscal 2022, increased by $7.1 million to $61,265,000 from $54,197,000 but decreased as a percentage of net sales by approximately 2.4% to 33.1% in fiscal 2022 from 35.5% in fiscal 2021. Service costs, including warehousing, freight and classroom delivery costs increased by $3,856,000 and decreased by 0.4% as a percentage of net sales. Selling costs increased by $2,365,000 and decreased as a percentage of sales by 0.9% compared to the prior year. Increased selling costs were attributable to increased variable expenses and because the sales force was able to return to traditional selling practices. G&A spending increased in terms of dollars but decreased as a percentage of net sales by 1.3%. Interest expense was $343,000 lower in fiscal 2022 compared to fiscal 2021 because of reduced levels of borrowing. 29 Provision for Income Taxes Our effective tax rate is based on recurring factors, including the forecasted mix of income before taxes in various jurisdictions, estimated permanent differences and the recording of a partial valuation allowance on net deferred tax asset. During 2022 and 2021 the Company incurred operating losses. When combined with operating results from 2020 the Company has incurred a cumulative operating loss for the last three years. While the Company has taken significant measures to return to profitability, and order rates at the beginning of the year are favorable, the short-term outlook for the school furniture market is challenging, particularly relating to ongoing supply chain difficulties. During the fourth quarter of the year ended January 31, 2022, based on this evaluation, and after considering future reversals of existing taxable temporary differences and the effects of seasonality on the Company’s business, the Company determined the realization of a majority of the net deferred tax assets no longer met the more likely than not criteria and a valuation allowance was recorded against the majority of the net deferred tax assets. Valuation allowances of $11,412,000 are needed for federal and certain state net operating loss carryforwards to reduce the carrying amount of deferred tax assets to an amount that is more likely than not to be realized. At January 31, 2022, the Company has net operating loss carryforwards of approximately $12,513,000 for U.S. federal, with no expirations, and $31,222,000 for state income tax purposes, expiring at various dates through January 31, 2041. Cash Flow The following table shows summary cash flows information for the years ended January 31, 2022 and 2021, respectively: Year ended January 31, 2022 2021 (In thousands) Net cash (used in) provided by operating activities $ (401) $ 7,799 Net cash used in investing activities (2,371) (2,135) Net cash provided by (used in) financing activities 3,729 (6,412) Net increase (decrease) in cash 957 (748) Operating activities. Our cash flows from operating activities are primarily collections from the sale and distribution of furniture to our customers in the education market. Net cash used in operating activities was $(0.4) million for the year ended January 31, 2022, a decrease of $8.2 million compared to the prior year. The decrease was primarily due to the timing of sales. Due to the seasonal nature of our business, the Company traditionally has low levels of sales in the fourth quarter. In the current year the Company experienced severe supply chain issues which delayed shipping activity. Fourth quarter sales more than doubled compared to the prior year, driving an $8 million increase in accounts receivable and contributing to a $9 million increase in inventory at fiscal year-end. In addition, the Company incurred increased material costs, which increased the dollar value of inventory at fiscal year end. Investing activities. Our investments primarily consist of investments in our factories and technology to support our business activities. Net investment activities were lower than typical for the years ended January 31, 2022 and January 31, 2021 due to reduced business activity related to the COVID pandemic. Capital expenditures have been financed using cash provided by operating activities and borrowings under our line of credit with PNC Bank. There were no material commitments for capital expenditures as of January 31, 2022. Financing activities. Our financing activities primarily consist of the proceeds and repayments of borrowings under our line of credit with PNC Bank. Due to the seasonal nature of our business, the Company typically borrows material amounts under the line to finance seasonal building of inventory and financing of accounts receivable. The Company typically repays the seasonal borrowings at the conclusion of the summer busy season. Inflation and Future Change in Prices We commit to annual contracts that determine selling prices for goods and services for periods of one year and occasionally longer. Though the Company has negotiated flexibility under many of these contracts that may allow the Company to increase prices on future orders, the Company may not have the ability to raise prices on orders received prior to any announced price increase. Due to the intensely seasonal nature of our business, the Company may receive significant orders during the first and second quarters for delivery in the second and third quarters. With respect to any of the contracts described above, if the costs 30 of providing our products or services increase between the date the orders are received and the shipping date, we may not be able to implement corresponding increases in our sales prices for such products or services to offset the related increased costs. In fiscal 2022 the cost of sales were volatile compared to prior years. The Company incurred material increases in steel, plastic and other materials. For fiscal 2023, the Company anticipates continued volatility in costs, particularly with respect to imported components from China, freight from China, certain raw materials including steel, transportation, energy, and potential impacts of escalating labor costs. Anticipated adverse volatility for fiscal 2023 could be severe in light of global supply chain and economic sanctions, tariffs imposed or threatened on imported commodities and disruptions caused by COVID-19 upon our suppliers. There is continued uncertainty with respect to steel and other raw material costs, including plastics, that are affected by the price of oil. Transportation costs may be adversely affected by increased oil prices, in the form of increased operation costs for our fleet, and surcharges on freight paid to third-party carriers. Virco depends upon third-party carriers for more than 90% of customer deliveries. Recent regulation and more stringent enforcement of federal regulations governing the transportation industry (especially regarding drivers) have adversely impacted the cost and availability of freight services. Virco expects to incur continued pressure on employee benefit costs. The Company has renewed health insurance contracts for its employees through December 2022, but costs after that date may be adversely impacted by current legislation, claim costs and industry consolidation. Virco has aggressively addressed these costs by controlling headcount, freezing pension benefits and passing on a portion of increased medical costs to employees. To recover the cumulative impact of increased costs, the Company has increased published list prices for fiscal 2023. Due to current economic conditions, the Company anticipates modestly increased price competition in fiscal 2023 and may not be able to raise prices in response to increased commodity costs without risk of losing market share. As a significant portion of Virco's business is obtained through competitive bids, the Company is carefully considering material and transportation costs as part of the bidding process. The Company is working to control and reduce costs by improving production and distribution methodologies, investigating new packaging and shipping materials and searching for new sources of purchased components and raw materials. Liquidity and Capital Resources Working Capital Requirements Virco addresses liquidity and working capital requirements in the context of short-term seasonal requirements and long-term capital requirements of the business. The Company's core business of selling furniture to publicly-funded educational institutions is extremely seasonal. The seasonal nature of this business permeates most of Virco's operational, capital and financing decisions. The Company's working capital requirements during and in anticipation of the peak summer season oblige management to make estimates and judgments that affect Virco's assets, liabilities, revenues and expenses. Management expends a significant amount of time during the year, and especially in the fourth quarter of the prior year and first quarter of current year, developing a stocking plan and estimating the number of employees, the amount of raw materials and the types of components and products that will be required during the peak season. If management underestimates any of these requirements, Virco's ability to fill customer orders on a timely basis or to provide adequate customer service may be diminished. If management overestimates any of these requirements, the Company may be required to absorb higher storage, labor and related costs, each of which may affect profitability. On an on-going basis, management evaluates such estimates, including those related to market demand, labor costs and inventory levels, and continually strives to improve Virco's ability to correctly forecast business requirements during the peak season each year. As part of Virco's efforts to address seasonality, financial performance and quality without sacrificing service or market share, management has been refining the Company's ATS operating model. ATS is Virco's version of mass-customization, which assembles standard, stocked components into customized configurations before shipment. The Company's ATS program reduces the total amount of inventory and working capital needed to support a given level of sales. It does this by increasing the inventory's versatility, delaying assembly until the last moment and reducing the amount of warehouse space needed to store finished goods. In order to provide “one-stop shopping” for all FF&E needs, Virco purchases and re-sells certain finished goods from other furniture manufacturers. When practical, these furniture items are drop shipped from the Company's supplier. Where cost effective, the Company will bring the item into the Virco warehouse and the third-party products will be shipped along with product manufactured by Virco. The Company did not carry material amounts of vendor inventory during the fiscal years ended January 31, 2022 and 2021. 31 In addition, Virco finances its largest balance of accounts receivable during the peak season. This occurs for three primary reasons. First, accounts receivable balances naturally increase during the peak season as shipments of products increase. Second, many customers during this period are government institutions, which tend to pay accounts receivable more slowly than commercial customers. Third, many summer deliveries may be “projects” where the Company fulfills large orders of furniture for a new school or significant refurbishment of an existing school. Customers with large projects may require architect sign off, school board approval prior to payment, or punch list completion, all of which can delay payment. Because of the seasonality of our business, our manufacturing and distribution capacity is dictated by the capacity requirement during the months of June, July and August. Because of this seasonality, factory utilization is lower during the slow season. The Company utilizes a variety of tactics to address the seasonality of its business. During the summer months, which comprise our second and third fiscal quarters, our personnel utilization generally is at or close to full capacity. The Company utilizes temporary labor and significant overtime to meet the seasonal requirements. During the slow portions of the year, temporary labor and overtime are eliminated to moderate the off-season costs. Our manufacturing facility capacity utilization generally remains less than 100% during these off-season months; because physical structure capacity cannot be adjusted as readily as personnel capacity, we have secured sufficient physical structure capacity to accommodate our current needs as well as for anticipated future growth. Our physical structure utilization is significantly lower during the first and fourth quarters of each year than it is during the second and third quarters. The Company utilizes a comparable strategy to address warehousing and distribution requirements. During summer months, temporary labor is hired to supplement experienced warehouse and distribution personnel. More than 90% of the Company's freight is provided by third-party carriers. The Company has secured sufficient warehouse capacity to accommodate our current needs as well as anticipated future growth. Line of Credit As the capital required for the summer season generally exceeds cash available from operations, Virco has historically relied on third-party bank financing to meet seasonal cash flow requirements. On December 22, 2011, the Company and Virco Inc., a wholly owned subsidiary of the Company (“Virco” and, together with the Company, the “Borrowers”) entered into a Revolving Credit and Security Agreement (“Credit Agreement”) with PNC Bank, National Association, as administrative agent and lender (“PNC”). On September 28, 2021, the Borrowers entered into an Amended and Restated Credit Agreement (the “Restated Credit Agreement”) with PNC that effectively incorporated all of the prior amendments to the Credit Agreement into an amended and restated form of agreement. The Restated Credit Agreement provides the Borrowers with a secured revolving line of credit (“Revolving Credit Facility”) of up to $65,000,000, with seasonal adjustments to the credit limit and subject to borrowing base limitations and includes a sub-limit of up to $3,000,000 for issuances of letters of credit. In addition, the Restated Credit Agreement provides an Equipment Line for purchases of equipment up to $2,000,000. The Revolving Credit Facility is an asset-based line of credit that is subject to a borrowing base limitation and generally provides for advances of up to 85% of eligible accounts receivable, plus a percentage equal to the lesser of 60% of the value of eligible inventory or 85% of the liquidation value of eligible inventory, plus $15,000,000 for the period from December to July of each year minus undrawn amounts of letters of credit and reserves. The Revolving Credit Facility is secured by substantially all of the Borrowers' personal property and certain of the Borrowers' real property. The original termination date of the Restated Credit Agreement was March 19, 2023, which date was extended to April 15, 2027, at which point the principal amount outstanding under the Restated Credit Agreement and any accrued and unpaid interest is due and payable, subject to certain prepayment penalties upon earlier termination. Prior to the maturity date, principal amounts outstanding under the Restated Credit Agreement may be repaid and reborrowed at the option of the Borrowers without premium or penalty, subject to borrowing base limitations, seasonal adjustments and certain other conditions. The Revolving Credit Facility bears interest, at the Borrowers' option, at either the Alternate Base Rate (as defined in the Restated Credit Agreement) or the Eurodollar Currency Rate (as defined in the Restated Credit Agreement), in each case plus an applicable margin. The applicable margin for Alternate Base Rate loans is a percentage within a range of 1.25% to 1.75%, and the applicable margin for Eurodollar Currency Rate loans is a percentage within a range of 2.25% to 2.75%, in each case based on the adjusted EBITDA (as defined in the Restated Credit Agreement, “EBITDA”) of the Borrowers at the end of each fiscal quarter and may be increased at PNC's option by 2.0% during the continuance of an event of default. Accrued interest with respect to principal amounts outstanding under the Restated Credit Agreement is payable in arrears on a monthly basis for Alternative Base Rate loans, and at the end of the applicable interest period but at most every three months for Eurodollar Currency Rate loans. The interest rate at January 31, 2022 was 5.0%. 32 The Restated Credit Agreement permits the Company to issue dividends or make payments with respect to the Company’s capital stock in an aggregate amount up to $3,000,000 during any fiscal year, provided that no default shall have occurred or is continuing or would result from any such payment, and the Company must demonstrate pro forma compliance with a 12-month trailing fixed charge coverage ratio of not less than 1.20:1.00 as of the fiscal quarter immediately preceding the date of any such dividend or payment. The original Credit Agreement required the Company to maintain compliance with a minimum fixed charge coverage ratio. The Company was in compliance with all quarterly debt covenants for the fiscal year ended January 31, 2020. In July 2020, the Company violated the fixed charge covenant of 1.1 to 1.0, but an amendment waived the violation and amended the covenant for the quarter ended October 31, 2020 to 1.0 to 1.0. In October 2020, the Company violated the fixed charge covenant of 1.0 to 1.0, but an amendment waived the violation and amended the fixed charge covenant to allow for a COVID addback of up to $2.0 million for costs incurred through April 30, 2021. After execution of the Restated Credit Agreement in September 2021, on December 7, 2021 the Company entered into Amendment No. 1 to the Restated Credit Agreement, which provided a limited waiver of the Company’s violation of the covenant to maintain a fixed charge coverage ratio of at least 1.10 to 1.00 for the four fiscal quarter periods ended October 31, 2021, and amended the fixed charge coverage ratio as follows: (i) 1.00 to 1.00 for each of the consecutive four fiscal quarter periods of Borrowers ending January 31, 2022 and April 30, 2022, and (ii) 1.10 to 1.00 for each consecutive four fiscal quarter periods of Borrowers ending thereafter. The Company was in violation of its financial covenants under the Restated Credit Agreement as of January 31, 2022, due to a decline in the Company’s net income primarily attributable to the effects of supply chain disruptions and labor shortages. On April 15, 2022, the Company entered into Amendment No. 2 to the Credit Agreement, which implemented the following changes to the Restated Credit Agreement and Revolving Credit Facility: i. extended the final maturity date of the Revolving Credit Facility from March 19, 2023 to April 15, 2027; ii. increased the borrowing limit from $65,000,000 to $70,000,000 in July 2022 and August 2022, and increased the borrowing limit from $40,000,000 to $45,000,000 in October 2022; iii. waived the Company’s violation of the covenant to maintain a fixed charge coverage ratio of at least 1.00 for the period ending January 31, 2022; iv. for the first and second quarters of fiscal 2023, implemented a temporary year-to-date adjusted EBITDA covenant in lieu of testing the fixed charge coverage ratio covenant as of such quarters, with quarterly testing of the fixed charge coverage ratio to resume for the third fiscal quarter and thereafter; v. permits a sale and leaseback transaction of the Company’s property at 1655 Amity Road and release of the lender’s pledge on the property, with the net proceeds to be used for a proposed share repurchase; vi. retired LIBOR pricing on the Revolving Credit Facility and replace with BSBY index, with pricing tiers and spreads to remain the same; vii. extended the P-card, ACH Credit, and ACH debit facilities for an additional year beyond their current maturities; and viii. Borrowers to pay a $250,000 extension fee and $75,000 waiver and amendment fee, with $200,000 due at closing and $125,000 due on the first anniversary of closing. The Restated Credit Agreement contains a clean-down provision that requires the Company to reduce borrowings under the line of credit to less than $10,000,000 for a period of 30 consecutive days during the Company’s fourth fiscal quarter of each fiscal year. The clean-down provision allows the Company to maintain the minimum outstanding balance of $10,000,000 to be carried on an uninterrupted period extending beyond one year and ultimately due at the scheduled maturity. The Company believes that normal operating cash flow will continue to allow it to meet the clean-down requirement with no adverse impact on the Company's liquidity. Events of default (subject to certain cure periods and other limitations) under the Restated Credit Agreement include, but are not limited to, (i) non-payment of principal, interest or other amounts due under the Restated Credit Agreement, (ii) the violation of terms, covenants, representations or warranties in the Restated Credit Agreement or related loan documents, (iii) any event of default under agreements governing certain indebtedness of the Borrowers and certain defaults by the Borrowers 33 under other agreements that would materially adversely affect the Borrowers, (iv) certain events of bankruptcy, insolvency or liquidation involving the Borrowers, (v) judgments or judicial actions against the Borrowers in excess of $250,000, subject to certain conditions, (vi) the failure of the Company to comply with Pension Benefit Plans (as defined in the Restated Credit Agreement), (vii) the invalidity of loan documents pertaining to the Restated Credit Agreement, (viii) a change of control of the Borrowers and (ix) the interruption of operations of any of the Borrowers' manufacturing facilities for five consecutive days during the peak season or 15 consecutive days during any other time, subject to certain conditions. Pursuant to the Restated Credit Agreement, substantially all of the Borrowers' accounts receivable are automatically and promptly swept to repay amounts outstanding under the Revolving Credit Facility upon receipt by the Borrowers. Due to this automatic liquidating nature of the Revolving Credit Facility, if the Borrowers breach any covenant, violate any representation or warranty or suffer a deterioration in their ability to borrow pursuant to the borrowing base calculation, the Borrowers may not have access to cash liquidity unless provided by PNC at its discretion. In addition, certain of the covenants and representations and warranties set forth in the Restated Credit Agreement contain limited or no materiality thresholds, and many of the representations and warranties must be true and correct in all material respects upon each borrowing, which the Borrowers expect to occur on an ongoing basis. Based on the Company’s current projections, including COVID-19 related costs, raw material costs and its ability to introduce price increases, management believes it will maintain compliance with the financial covenants within Amendment No. 2, although there are uncertainties therewithin, such as raw material costs and supply chain challenges. The Company's line of credit with PNC is structured to provide seasonal credit availability during the Company's peak summer season. Approximately $20,449,000 was available for borrowing as of January 31, 2022. Long-Term Capital Requirements In addition to short-term liquidity considerations, the Company continually evaluates long-term capital requirements. Capital expenditures will continue to focus on automation, both in the factory and software applications, and new product development along with the tooling and new processes required to produce new products. The Company has identified several opportunities for capital expenditures during the next five years. The Company anticipates capital spending of no more than $5,000,000 for fiscal 2023. Our Revolving Credit Facility with PNC Bank provides a line for equipment and covenants allow for anticipated capital expenditures for fiscal 2023. Retirement Obligations The Company provides retirement benefits to employees under two defined benefit retirement plans; the Employee Plan and the VIP Plan. The Employee Plan is a qualified retirement plan that is funded through a trust held at PNC Bank ("Trustee"). The other plan is non-qualified retirement plan. Benefits payable under the VIP Plan are secured by life insurance policies and marketable securities held in a rabbi trust. The Company obtains annual actuarial valuations for both retirement plans. Because the plans have been frozen since 2003, there is no service cost related to the plans. In past, due to a large number of lump sum benefits paid to retired and terminated employees, the Company has incurred settlement costs for the Employee Plan. In effort to “de-risk” the Employee Plan, the Company intends to continue to reach out to and offer lump sum benefits to terminated and retired employees, which may result in settlement costs in the future. The Company incurred settlement costs in the second, third, and fourth quarters of fiscal 2022. The Company did not incur settlement costs in fiscal 2021. It is the Company's policy to contribute adequate funds to the trust accounts to cover benefit payments under the VIP Plan and to maintain the funded status of the Employee Plan at a level which is adequate to avoid significant restrictions to the Employee Plan under the Pension Protection Act of 2006. Contributions to the Qualified Plan Trust and benefit payments under the VIP Plan totaled $654,000 in fiscal 2022 and $604,000 in fiscal 2021. Contributions during fiscal 2023 will depend upon actual investment results and benefit payments but are anticipated to be approximately $615,000. At January 31, 2022, accumulated other comprehensive loss of approximately $6.0 million, net of tax, is attributable to the pension plans. The Company does not anticipate making any significant changes to the pension assumptions in the near future. If the Company were to have used different assumptions in the fiscal year ended January 31, 2022, a 1% reduction in investment return would have increased expense by approximately $210,000, a 1% change in the rate of compensation increase would have no impact, and a 1% reduction in discount rates would cause obligations under the Plans to increase by approximately $7.6 million and increase pension expense by approximately $801,000. 34 Table of Contents Stockholders' Equity Historically it has been the board of directors' policy to periodically review the payment of cash and stock dividends in light of the Company's earnings and liquidity. The Company paid four quarterly cash dividends of $0.015 per share in 2018. Virco issued a 10% stock dividend or 3/2 stock split every year beginning in 1983 through 2003. Although the stock dividend had no cash consequences to the Company, the accounting methodology required for 10% dividends has affected the equity section of the balance sheet. When the Company records a 10% stock dividend, 10% of the market capitalization of the Company on the date of the declaration is reclassified from retained earnings to additional paid-in capital. During the period from 1983 through 2003, the cumulative effect of the stock dividends has been to reclassify over $122 million from retained earnings to additional paid-in capital. The equity section of the balance sheet on January 31, 2022 reflects additional paid-in capital of approximately $120 million and accumulated deficit of approximately $67 million. Other than the losses incurred during 2004-2006, 2011-2014, 2018-2019, and 2021–2022, the accumulated deficit is a result of the accounting reclassification and is not the result of accumulated losses. Environmental and Contingent Liabilities Environmental Compliance Virco is subject to numerous federal, state and local environmental laws and regulations in the various jurisdictions in which it operates that (a) govern operations that may have adverse environmental effects, such as the discharge of materials into the environment, as well as handling, storage, transportation and disposal practices for solid and hazardous wastes, and (b) impose liability for response costs and certain damages resulting from past and current spills, disposals or other releases of hazardous materials. In this context, Virco works diligently to remain in compliance with all such environmental laws and regulations as these affect the Company's operations. Moreover, Virco has enacted policies for recycling and resource recovery that have earned repeated commendations, including: recognition by the California Department of Resources Recycling and Recovery ("CalRecycle") in 2012 and 2011 as a Waste Reduction Awards Program ("WRAP") honoree; recognition by the United States Environmental Protection Agency in 2019 as a WasteWise Winner for reducing waste, in 2004 as a WasteWise Hall of Fame Charter Member, in 2003 as a WasteWise Partner of the Year and in 2002 as a WasteWise Program Champion for Large Businesses; and recognition by the Sanitation Districts of Los Angeles County for compliance with industrial waste water discharge guidelines in 2008 through 2011. This is only a partial list of Virco's environmental awards and commendations; for a more complete list, go to www.virco.com. In addition to these awards and commendations, Virco's ZUMA and ZUMAfrd product lines were the first classroom furniture collections to earn indoor air quality certification through the stringent GREENGUARD® Children & Schools Program, now known as Greenguard Gold certification. As a follow-up to the certification of ZUMA and ZUMAfrd models in 2006, hundreds of other Virco furniture items - including Analogy furniture models and Textameter instructor workstations - have earned GREENGUARD certification. Moreover, all Virco products covered by the Consumer Product Safety Improvement Act of 2008 are in compliance with this legislation. All affected Virco models are also in compliance with the California Air Resources Board rule and Toxic Control Substances Act rule concerning formaldehyde emissions from composite wood products. Environmental laws have changed rapidly in recent years, and Virco may be subject to more stringent environmental laws in the future. The Company has expended, and may be expected to continue to expend, significant amounts in the future for compliance with environmental rules and regulations, for the investigation of environmental conditions, for the installation of environmental control equipment or remediation of environmental contamination. Normal recurring expenses relating to operating our factories in a manner that meets or exceeds environmental laws are matched to the cost of producing inventory. It is possible that the Company's operations may result in noncompliance with, or liability for remediation pursuant to, environmental laws. Should such eventualities occur, the Company records liabilities for remediation costs when remediation costs are probable and can be reasonably estimated. See “ Item 1A. Risk Factors: We could be required to incur substantial costs to comply with environmental and other legal requirements .” Violations of, and liabilities under, environmental laws and regulations may increase our costs or require us to change our business practices. Contingent Liabilities In fiscal 2022 and 2021, the Company was self-insured for product liability losses of up to $250,000 per occurrence, general liability losses of up to $50,000 per occurrence, workers' compensation losses up to $250,000 per accident and auto liability up to $50,000 per accident. In prior years the Company has been partially self-insured for workers' compensation, automobile, product, and general liability losses. The Company has purchased insurance to cover losses in excess of the self-insured retention or deductible up to a limit of $30,000,000. For the insurance year beginning April 1, 2022, the Company will be self-insured for product liability losses up to $250,000 per occurrence, general liability losses up to $50,000 per occurrence, workers' compensation losses up to $250,000 per occurrence, and auto liability up to $50,000 per occurrence. In future years, 35 the Company's exposure to self-insured retentions will vary depending upon the market conditions in the insurance industry and the availability of cost-effective insurance coverage. The Company has aggressively pursued a program to improve product quality, reduce product liability claims and losses and to aggressively defend product liability cases. This program has continued through fiscal 2022 and has resulted in reductions in product liability claims and litigated product liability cases. In addition, the Company has active safety programs to improve plant safety and control workers' compensation losses. Under California Workers Compensation law, COVID-19 is subject to workers compensation unless the Company can prove that the employee contracted COVID-19 outside the workplace. As of January 31, 2022, the Company has incurred no significant workers compensation claims related to COVID-19. Management does not anticipate that any related settlement, after consideration of the existing reserves for claims and potential insurance recovery, would have a material adverse effect on the Company's financial position, results of operations or cash flows. Off-Balance Sheet Arrangements The Company did not enter into any material off-balance sheet arrangements during fiscal 2022, nor did the Company have any material off-balance sheet arrangements outstanding at January 31, 2022. New Accounting Pronouncements See disclosure of recently adopted and recently issued but not yet adopted accounting standards in Note 2 to the Consolidated Financial Statements contained in "Item 8. Financial Statements and Supplementary Data" to this Annual Report on Form 10-K. Item 7A. Quantitative and Qualitative Disclosures about Market Risk The Company is a smaller reporting company as defined by Rule 12b-2 of the Exchange Act as of our second quarter of fiscal 2022 and are not required to provide the information under this item. 36