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LGL GROUP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Note Regarding Forward Looking Statements Information included or incorporated by reference in this Quarterly Report on Form 10-Q may contain forward-looking statements. This information may involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different than the future results, performance or achievements expressed or implied by any forward-looking statements. Forward-looking statements, which involve assumptions and describe our future plans, strategies and expectations, are generally identifiable by use of the words "may," "should," "expect," "anticipate," "estimate," "believe," "intend" or "project" or the negative of these words or other variations on these words or comparable terminology. Examples of forward-looking statements include, but are not limited to, statements regarding efforts to grow revenue, expectations regarding fulfillment of backlog, future benefits to operating margins and the adequacy of cash resources. Actual events or results may differ materially from those discussed in forward-looking statements as a result of various factors, including, without limitation, the risks outlined under "Risk Factors" in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 24, 2011. In light of these risks and uncertainties, there can be no assurance that the forward-looking statements contained in this Quarterly Report on Form 10-Q will in fact be accurate. Further, we do not undertake any obligation to publicly update any forward-looking statements. As a result, you should not place undue reliance on these forward-looking statements. Results of Operations Three months ended June 30, 2011, compared to three months ended June 30, 2010 Consolidated Revenues and Gross Margin Consolidated revenues decreased by $2,889,000, or 23.0%, to $9,646,000 for the three-month period ended 2011 from $12,535,000 for the comparable period in 2010. The decrease was primarily the result of a reduction in order activity for the Military, Instrumentation, Space and Avionics ("MISA") market segment due to uncertainty related to government budget and spending cycles. Revenue for the quarter ended June 30, 2010 also included the impact of a new product line of double-oven oscillators that entered production during that period. The Company is continuing its efforts to grow revenue by working to gain market share with new and existing customers, as well as by continuing its product development efforts to serve additional segments of the timing and frequency equipment market, such as alternative energy management, energy exploration, military personnel protection and homeland security. As of June 30, 2011, the Company's order backlog was $12,093,000, which was a decrease of 1.2% compared to the backlog as of March 31, 2011, which was $12,238,000, and a decrease of 15.9% compared to the backlog as of June 30, 2010, which was $14,373,000. The decrease in backlog is primarily due to reduced order activity from our existing customers in the MISA market segment, and extended order request dates that fall outside of the 12-month timeframe reflected in the order backlog. The backlog of unfilled orders includes amounts based on signed contracts as well as other agreements we have determined are legally binding and likely to proceed. Although backlog represents only business that is considered likely to be performed, cancellations or scope adjustments may and do occur. Backlog is adjusted quarterly to reflect project cancellations, deferrals, revised project scope and cost, and sales of subsidiaries, if any. The Company expects to fill substantially its entire current backlog in 2011, but cannot provide assurance as to the portion of the backlog to be fulfilled in a given year. Consolidated gross margin, which is consolidated revenues less manufacturing cost of sales, as a percentage of revenues decreased to 31.8% for the second quarter 2011 from 36.3% for the comparable period in 2010. This - Page 14 --------------------------------------------------------------------------------- decrease is due primarily to the reduction in revenues from the comparable period in 2010, which eroded gross margin by spreading fixed infrastructure costs over a smaller revenue base. The Company is continuing its efforts to further improve its manufacturing and supply chain efficiency. Operating Income Operating income was $564,000 for the second quarter of 2011 compared to $2,351,000 for the comparable period in 2010. This decrease is primarily the result of a 4.5% decrease in gross margin, which was mainly the result of the 23.0% decrease in revenues as compared to the same period in 2010. The decrease was also attributable to an increase in engineering, selling and administrative expenses as compared to the same period in 2010, primarily due to an increase in the Company's investment in engineering and marketing efforts to introduce new product designs and increase its market share. Interest expense Interest expense was $29,000 for the three-month period ended June 30, 2011, which was a decrease of $83,000 from $112,000 for the three-month period ended June 30, 2010. The decrease was primarily due to a $0 balance outstanding on MtronPTI's revolving credit facility with FNBO during the quarter ended June 30, 2011, as well as the repayment of our term loan with RBC Centura Bank on September 30, 2010. Net Income Net income for the second quarter 2011 was $346,000 compared to net income of $2,177,000 for the comparable period in 2010. The decrease was primarily attributable to a 23.0% decrease in revenues for the three-month period ended June 30, 2011, as compared to the same period in 2010, a 4.5% decrease in gross margin, as well as an increase in the income tax provision of ($96,000) to ($194,000) for the three months ended June 30, 2011, compared to ($98,000) in same period in 2010, due to an increase in the estimated full year effective income tax rate for 2011. Basic and diluted net income per share for the period ended June 30, 2011, was $0.13 compared with $0.97 for the period ended June 30, 2010. The decrease in basic and diluted earnings per share was also attributable to the 16.5% increase in the weighted average number of shares outstanding, which was 2,617,260 for the three months ended June 30, 2011, compared to 2,245,970 for same period in 2010. The increase in the weighted average number of shares is due primarily to the additional 350,000 shares sold by the Company in its public offering completed in February 2011 (the "Public Offering"). Results of Operations Six months ended June 30, 2011, compared to six months ended June 30, 2010 Consolidated Revenues and Gross Margin Consolidated revenues decreased by $4,570,000, or 19.7%, to $18,666,000 for the six-month period ended June 30, 2011, from $23,236,000 for the comparable period in 2010. The decrease was primarily the result of a reduction in order activity for the MISA market segment due to uncertainty related to government budget and spending cycles. Revenue for the six months ended June 30, 2010, also included the impact of a new product line of cavity filters and a new product line of double-oven oscillators that entered production during that period. The Company is continuing its efforts to grow revenue by working to gain market share with new and existing customers, as well as by continuing its product development efforts to serve additional segments of the timing and frequency equipment market, such as alternative energy management, energy exploration, military personnel protection and homeland security. As of June 30, 2011, the Company's order backlog was $12,093,000, which was an increase of 12.7% compared to the backlog as of December 31, 2010, which was $10,734,000, and a decrease of 15.9% compared to - Page 15 --------------------------------------------------------------------------------- the backlog as of June 30, 2010, which was $14,373,000. The decrease in backlog from December 31, 2010, is primarily due to reduced order activity from our existing customers in the MISA market segment, and extended order request dates that fall outside of the 12-month timeframe reflected in the order backlog. The backlog of unfilled orders includes amounts based on signed contracts as well as other agreements we have determined are legally binding and likely to proceed. Although backlog represents only business that is considered likely to be performed, cancellations or scope adjustments may and do occur. Backlog is adjusted quarterly to reflect project cancellations, deferrals, revised project scope and cost, and sales of subsidiaries, if any. The Company expects to fill substantially its entire current backlog in 2011, but cannot provide assurance as to the portion of the backlog to be fulfilled in a given year. Consolidated gross margin, which is consolidated revenues less manufacturing cost of sales, as a percentage of revenues decreased to 32.2% for the six-month period ended June 30, 2011, from 35.3% for the comparable period in 2010. This decrease is due primarily to the 19.7% decrease in revenues compared to the comparable period in 2010, which reduced gross margin by spreading fixed infrastructure costs over a smaller revenue base. The Company is continuing its efforts to further improve its manufacturing and supply chain efficiency. Operating Income Operating income was $947,000 for the six months ended June 30, 2011, compared to $3,555,000 for the comparable period in 2010. This decrease is primarily the result of a 3.1% decrease in gross margin, which was mainly the result of the 19.7% decrease in revenues as compared to the same period in 2010. The decrease was also attributable to an increase in engineering, selling and administrative expenses as compared to the same period in 2010, primarily due to an increase in the Company's investment in its engineering and marketing efforts to introduce new product designs and increase its market share. Interest expense Interest expense was $41,000 for the six-month period ended June 30, 2011, which was a decrease of $176,000 from $217,000 for the comparable period in 2010. The decrease was primarily due to a $0 balance outstanding on MtronPTI's revolving credit facility with FNBO during the quarter ended June 30, 2011, as well as the repayment of our term loan with RBC Centura Bank on September 30, 2010. Income Taxes The effective income tax rate for the six months ended June 30, 2011 was 36.2%, compared to an effective income tax rate of 3.6% for the six months ended June 30, 2010. The effective income tax rate for the six months ended June 30, 2010, was significantly lower due to the projected utilization of the Company's net operating loss carryforwards, which were offset by the effect of the valuation allowance against those deferred tax assets, resulting in a reduction in the provision for income taxes recognized in that period. The valuation allowance against the Company's deferred tax assets was released as of December 31, 2010. Beginning in the quarter ended March 31, 2011 and going forward, the Company, if it generates taxable income, will have a more normalized effective income tax rate, but does not expect to pay cash for federal income taxes until the remainder of its deferred tax assets related to net operating loss carryforwards have been utilized. Net Income Net income for the six-month period ended June 30, 2011, was $587,000 compared to net income of $3,243,000 for the comparable period in 2010. The decrease was primarily attributable to a 19.7% decrease in revenues for the six-month period ended June 30, 2011, as compared to the same period in 2010, a 3.1% decrease in gross margin, as well as an increase in the income tax provision of ($207,000) to ($333,000) for the six months ended June 30, 2011, compared to ($126,000) in same period in 2010, due to an increase in the estimated full year effective income tax - Page 16 --------------------------------------------------------------------------------- rate for 2011. Basic and diluted net income per share for the six months ended June 30, 2011, was $0.23 compared with $1.44 for the six months ended June 30, 2010. The decrease in basic and diluted earnings per share was also attributable to the 13.6% increase in the weighted average number of shares outstanding, which was 2,549,580 for the six months ended June 30, 2011, compared to 2,244,851 for same period in 2010. The increase in the weighted average number of shares is due primarily to the additional 350,000 shares sold by the Company in the Public Offering completed in February 2011. Liquidity and Capital Resources The Company's cash and cash equivalents at June 30, 2011 were $10,985,000 as compared to $4,147,000 at December 31, 2010. At June 30, 2011, MtronPTI had $0 outstanding and available borrowing capacity of $4,000,000 under the Chase Revolving Loan and $2,000,000 under the Chase Commercial Loan, compared with $0 outstanding and available borrowing capacity of $4,000,000 at December 31, 2010 under the FNBO Revolving Loan. At June 30, 2011, the Company's consolidated working capital was $19,298,000, as compared to $12,829,000 at December 31, 2010. At June 30, 2011, the Company had current assets of $24,649,000 and current liabilities of $5,351,000. The ratio of current assets to current liabilities was 4.61 to 1.00 at June 30, 2011, compared to 3.75 to 1.00 at December 31, 2010. The increase in net working capital is primarily due to the increase in the Company's cash and cash equivalents balance as a result of the net proceeds of $6,404,000 from the Company's Public Offering of 350,000 shares of its common stock completed on February 4, 2011. Cash provided by operating activities was $1,733,000 for the six months ended June 30, 2011, compared to cash provided by operating activities of $808,000 for the six months ended June 30, 2010. The increase in cash provided by operating activities is due to the net collection of accounts receivable of $592,000 compared to the net increase of accounts receivable of $2,215,000 during the same period in 2010, a use of cash resulting from an increase in the inventory balance of ($922,000) compared to an increase of ($1,076,000) during the same period in 2010, an increase in the change in deferred taxes of $213,000 compared to no change during the same period in 2010, as well as an increase in trade accounts payable, accrued liabilities and other liabilities of $717,000 compared to $300,000 during the same period in 2010. This was offset by a decrease in net income to $587,000 for the six months ended June 30, 2011 from $3,243,000 for the six months ended June 30, 2010. Cash used in investing activities was ($1,166,000) for the six months ended June 30, 2011, compared to ($168,000) for the same period in 2010. The increase was due primarily to the Company's continued investment in machinery and equipment related to new production activities and replacement of obsolete equipment as needed, as well as an investment of ($242,000) in software to replace the Company's existing enterprise resource planning systems, which is being implemented during 2011. Cash provided by financing activities from operations was $6,271,000 for the six months ended June 30, 2011, compared with cash used in financing activities of ($845,000) for the same period in 2010. The increase in cash provided by financing activities is due to the Company's completion of the Public Offering on February 4, 2011, resulting in net proceeds of $6,404,000 for the six months ended June 30, 2011. At June 30, 2011, total liabilities of $5,552,000 was $523,000 greater than the total liabilities at December 31, 2010, of $5,029,000. The increase in total liabilities was primarily due to an increase in trade accounts payable of $847,000, which was partially offset by a decrease in other accrued expenses of $336,000. At June 30, 2011, the Company had $335,000 in current maturities of long-term debt compared with $299,000 at December 31, 2010. On June 30, 2011, certain of the Company's subsidiaries, together referred to as MtronPTI, entered into the Chase Loan Agreement with Chase. The Chase Loan Agreement provides for the following credit facilities: (i) a revolving line of credit in the amount of $4,000,000, to be used solely for working capital needs, referred to as the Chase Revolving Loan, (ii) a commercial line of credit in the amount of $2,000,000, to be used solely for tangible capital expenditures and, at Chase's sole discretion, business acquisitions, referred to as the Chase Commercial Loan, and (iii) a term loan in the amount of $536,000, referred to as the Chase Term Loan. The Chase Revolving Loan bears interest at the greater of (x) Chase's prime rate or (y) the one-month LIBOR rate plus 2.50% - Page 17 --------------------------------------------------------------------------------- per annum, referred to as the CB Rate, with interest due and payable on a monthly basis and the outstanding principal balance plus all accrued but unpaid interest due and payable on June 30, 2013. The Chase Commercial Loan bears interest at the CB Rate, with interest due and payable on a monthly basis and the outstanding principal balance plus all accrued but unpaid interest due and payable on June 30, 2012. The Chase Term Loan bears interest at 5.00% per annum, with principal and interest due and payable in monthly installments of $29,500 and the outstanding principal balance, plus all accrued but unpaid interest due and payable on January 31, 2013. All outstanding obligations of MtronPTI under the Chase Loan Agreement are collateralized by a first priority security interest in all of the assets of MtronPTI, excluding real property. Additionally, in connection with the Chase Loan Agreement, Piezo entered into a separate agreement with Chase providing that Piezo would not mortgage or otherwise encumber certain real property it owns in Florida while the credit facilities under the Chase Loan Agreement are outstanding. The Chase Loan Agreement contains a variety of affirmative and negative covenants, including, but not limited to, financial covenants that MtronPTI maintain: (i) tangible net worth not less than the sum of $7,500,000, plus 50% of the net income earned by MtronPTI for the preceding six-month period at June 30, 2011, with the threshold amount continuing to increase at December 31st and June 30th of each year by 50% of the net income earned by MtronPTI for the preceding six months; (ii) net income of not less than $1,000,000 for the fiscal year-to-date period ending June 30, 2011, $1,500,000 for the fiscal year-to-date period ending September 30, 2011, and $2,000,000 for the fiscal year-to-date period ending December 31, 2011 and thereafter, provided that MtronPTI not exhibit two consecutive quarterly losses; and (iii) a debt service coverage ratio of not less than 1.25 to 1.00, tested at the end of every fiscal year. At June 30, 2011, MtronPTI was in compliance with all covenants under the Chase Loan Agreement. The Company believes that existing cash and cash equivalents, cash generated from operations and available borrowings on its revolving line of credit will be sufficient to meet its ongoing working capital and capital expenditure requirements for the next 12 months. However, the Company may need to seek additional capital to fund future growth in its business, to provide flexibility to respond to dynamic market conditions, or to fund its strategic growth objectives. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements. Critical Accounting Policies Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of such statements requires us to make estimates and assumptions that affect the reported amounts of revenues and expenses during the reporting period and the reported amounts of assets and liabilities as of the date of the financial statements. Our estimates are based on historical experience and other assumptions that we consider to be reasonable given the circumstances. Actual results may vary from our estimates. The Company's most critical accounting policies include revenue recognition, accounts receivable allowance, valuation of inventories, accounting for warranty obligations, accounting for income taxes, and accounting for stock-based compensation. - Page 18 --------------------------------------------------------------------------------- Revenue Recognition The Company recognizes revenue from the sale of its product in accordance with the criteria in ASC 605, Revenue Recognition, which are: · persuasive evidence that an arrangement exists; · delivery has occurred; · the seller's price to the buyer is fixed and determinable; and · collectability is reasonably assured. The Company meets these conditions upon shipment because title and risk of loss passes to the customer at that time. However, the Company offers a limited right of return and/or authorized price protection provisions in its agreements with certain electronic component distributors who resell the Company's products to original equipment manufacturers or electronic manufacturing services companies. As a result, the Company estimates and records a reserve for future returns and other charges against revenue at the time of shipment consistent with the terms of sale. The reserve is estimated based on historical experience with each respective distributor. Since inception of these agreements and to date, the Company has not been required to perform under the authorized price protection provisions and therefore has not established a reserve for this purpose. The Company recognizes revenue related to transactions with a right of return and/or authorized price protection provisions when the following conditions are met: · seller's price to the buyer is fixed or determinable at the date of sale; · buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; · buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product; · buyer acquiring the product for resale has economic substance apart from that provided by the seller; · seller does not have obligations for future performance; and · the amount of future returns can be reasonably estimated. Accounts Receivable Allowance Accounts receivable on a consolidated basis consist principally of amounts due from both domestic and foreign customers. Credit is extended based on an evaluation of the customer's financial condition and collateral is not generally required. In relation to export sales, the Company requires letters of credit supporting a significant portion of the sales price prior to production to limit exposure to credit risk. Certain credit sales are made to industries that are subject to cyclical economic changes. The Company maintains an allowance for doubtful accounts at a level that management believes is sufficient to cover potential credit losses. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. Estimates are based on historical collection experience, current trends, credit policy and relationship between accounts receivable and revenues. In determining these estimates, the Company examines historical write-offs of its receivables and reviews each client's account to identify any specific customer collection issues. If the financial condition of its customers were to deteriorate, resulting in an impairment of their ability to make payment, additional allowances might be required. The Company's failure to accurately estimate the losses for doubtful accounts and ensure that payments are received on a timely basis could have a material adverse effect on its business, financial condition and results of operations. - Page 19 --------------------------------------------------------------------------------- Inventory Valuation Inventories are stated at the lower of cost or market value using the FIFO (first-in, first-out) method. The Company maintains a reserve for inventory based on estimated losses that result from inventory that becomes obsolete as of period end. In determining these estimates, the Company performs an analysis on demand and usage for each inventory item over historical time periods. Based on that analysis, the Company reserves a percentage of the inventory amount within each time period based on historical demand and usage patterns of specific items in inventory. Warranties The Company offers a standard one-year warranty. The Company tests its products prior to shipment in order to ensure that they meet each customer's requirements based upon specifications received from each customer at the time its order is received and accepted. The Company's customers may request to return products for various reasons, including but not limited to the customers' belief that the products are not performing to specification. The Company's return policy states that it will only accept product returns with prior authorization and if the product does not meet customer specifications, in which case the product would be replaced or repaired. To accommodate the Company's customers, each request for return is reviewed, and if and when it is approved, a return materials authorization ("RMA") is issued to the customer. Each month the Company records a specific warranty reserve for approved RMAs covering products that have not yet been returned. The Company does not maintain a general warranty reserve because, historically, valid warranty returns resulting from a product not meeting specifications or being non-functional have been immaterial. Income Taxes The Company's deferred income tax assets represent temporary differences between the financial statement carrying amount and the tax basis of existing assets and liabilities that will result in deductible amounts in future years, including net operating loss carryforwards. Based on estimates, the carrying value of our net deferred tax assets assumes that it is more likely than not that the Company will be able to generate sufficient future taxable income in certain tax jurisdictions. Our judgments regarding future profitability may change due to future market conditions, changes in U.S. or international tax laws and other factors. If, in the future, the Company experiences losses for a sustained period of time, the Company may not be able to conclude that it is more likely than not that the Company will be able to generate sufficient future taxable income to realize our deferred tax assets. If this occurs, the Company may be required to increase the valuation allowance against the deferred tax assets resulting in additional income tax expense. - Page 20 --------------------------------------------------------------------------------- Stock-Based Compensation The Company adopted the provisions of Accounting Standards Codification ("ASC") Topic 718, Share-Based Payments ("ASC 718"), beginning January 1, 2006, using the modified prospective transition method. ASC 718 requires the Company to measure the cost of employee services in exchange for an award of equity instruments based on the grant-date fair value of the award and to recognize cost over the requisite service period. Under the modified prospective transition method, financial statements for periods prior to the date of adoption are not adjusted for the change in accounting. However, the compensation expense is recognized for (a) all share-based payments granted after the effective date under ASC 718, and (b) all awards granted under ASC 718 to employees prior to the effective date that remain unvested on the effective date. The Company recognizes compensation expense on fixed awards with pro rata vesting on a straight-line basis over the service period. The Company estimates the fair value of stock-based compensation on the grant date using the Black-Scholes-Merton option-pricing model. The Black-Scholes-Merton option-pricing model requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. There is no expected dividend rate. Historical Company information was the primary basis for the expected volatility assumption. Grants from prior years were calculated using historical volatility as the Company believes that the historical volatility over the life of the option is more indicative of the option's expected volatility in the future. The risk-free interest rate is based on the U.S. Treasury zero-coupon rate with a remaining term equal to the expected term of the option. ASC 718 also requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. |