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WSI INDUSTRIES, INC. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations
[October 24, 2014]

WSI INDUSTRIES, INC. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations


(Edgar Glimpses Via Acquire Media NewsEdge) Critical Accounting Policies and Estimates: Management's Discussion and Analysis of Financial Condition and Results of Operations discuss our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities.



We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the result of which forms the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Results may differ from these estimates due to actual outcomes being different from those on which we based our assumptions. The estimates and judgments utilized are reviewed by management on an ongoing basis and by the audit committee of our board of directors at the end of each quarter prior to the public release of our financial results. We made no significant changes to our critical accounting policies during fiscal 2014.

Application of Critical Accounting Policies: Excess and Obsolete Inventory: Inventories, which are composed of raw materials, work in process and finished goods, are valued at the lower of cost or market by comparing the cost of each item in inventory to its most recent sales price or sales order price. Inventory cost is adjusted down for any excess cost over net realizable value of inventory components.


In addition, the Company determines whether its inventory is obsolete by analyzing the sales history of its inventory, sales orders on hand and indications from the Company's customers as to the future of various parts or programs. If, in the Company's determination, the inventory value has become impaired, the Company adjusts the inventory value to the amount the Company estimates as the ultimate net realizable value for that inventory. Actual customer requirements in any future periods are inherently uncertain and thus may differ from our estimates. The Company performs its lower of cost or market testing, as well as its excess or obsolete inventory analyses, quarterly.

The Company has no specific timeline to dispose of its remaining obsolete inventory and intends to sell this obsolete inventory from time to time, as market conditions allow.

Goodwill Impairment: The Company evaluates the valuation of its goodwill according to the provisions of Accounting Standards Codification ("ASC") 350 to determine if the current value of goodwill has been impaired. The Company believes that its stock price is not necessarily an indicator of the Company's value given its limited trading volume and its wide price fluctuations. The Company has also adopted Accounting Standard Update (ASU) No. 2011-08, Intangibles-Goodwill and Other (Topic 350).

With ASU No. 2011-08, an entity is given the option to make a qualitative evaluation of goodwill impairment to determine whether it should calculate the fair value of its reporting unit. In the fiscal 2014 fourth quarter, the Company made its qualitative evaluation of its goodwill considering, among other things, the overall macroeconomic conditions, industry and market considerations, overall financial performance and other relevant company specific events. Based on this qualitative evaluation, the Company concluded that it was more likely than not that its goodwill was not impaired and that it wasn't required to calculate the fair value of its reporting unit. If the Company has changes in events or circumstances, including reductions in anticipated cash flows generated by its operations, goodwill could become impaired which would result in a charge to earnings.

9 -------------------------------------------------------------------------------- Deferred Taxes: The Company accounts for income taxes using the liability method. Deferred income taxes are provided for temporary differences between the financial reporting and tax bases of assets and liabilities. A deferred tax valuation allowance is set up should the realization of any deferred taxes become less likely than not to occur. The valuation allowance is analyzed periodically by the Company and may result in income tax expense being different than statutory rates. The Company has not established a valuation allowance as it believes it is more likely than not that it will fully realize the benefit of its tax assets. Currently, the Company's deferred tax assets consists primarily of the Company's alternative minimum tax (AMT) tax credit carryforward. The Company's AMT tax credit carryforward does not expire. The Company believes that given that the AMT tax credit carryforward doesn't expire and also the Company's profitability in recent years that the Company is more likely than not to fully utilize its tax credit carryforwards. However, a significant loss of a customer or a change in the Company's business could affect the realization of the deferred tax assets. If a major program were discontinued, the Company would immediately assess the impact of the loss of the program on the realization of the deferred tax assets.

Revenue Recognition: The Company considers its revenue recognition policy to fall under the guidance of FASB's conceptual framework for revenue recognition. The Company recognizes revenue only after: (a) The Company has received a purchase order identifying price and delivery terms or services to be rendered; (b) shipment has occurred, or in the case of services, after the service has been completed; (c) the Company's price is fixed as evidenced by the purchase order; and (d) collectability is reasonably assured. The Company continually monitors its accounts receivable for any delinquent or slow paying accounts. The Company believes that based upon its past history with minimal bad debt write-offs, that all accounts are collectible upon shipment or delivery of services. Credit losses from customers have been minimal and within management's expectations.

Based on management's evaluation of uncollected accounts receivable, bad debts are provided for on the allowance method. Accounts are considered delinquent if they are 120 days past due. If an uncollectible account should arise during the year, it would be written-off at the point it was determined to be uncollectible. The Company mitigates its credit risk by performing periodic credit checks and actively pursuing past due accounts. The Company refers to "net sales" in its consolidated statements of operations as the Company's sales are sometimes reduced by product returned by its customers.

Liquidity and Capital Resources: The Company's net working capital at the end of fiscal 2014 was $7,967,000 as compared to $5,943,000 at the end of fiscal 2013. The increase occurred due to an increase in cash primarily attributable to $3,925,000 in cash generated from operations, as well as the increase in accounts receivable and inventories due to the increase in the level of the Company's business. The ratio of current assets to current liabilities increased to 2.49 to 1.0 at August 31, 2014 from 2.19 to 1.0 at the end of the prior fiscal year due primarily to reasons described above. The Company generated $3,925,000, $2,021,000 and $2,188,000 in cash from operations in fiscal 2014, 2013 and 2012, respectively.

10 --------------------------------------------------------------------------------In fiscal 2014 and fiscal 2013, additions to property, plant and equipment either by cash or financing were $229,000 and $7,849,000, respectively. In fiscal 2013, the Company entered into a new mortgage that provided $3,152,000 of financing for the Company's building addition. The Company also entered financing agreements of $3,628,000 for machinery acquired in fiscal 2013. In fiscal 2012, the Company had $3,696,000 in additions to property, plant and equipment, of which $3,114,000 was acquired using financing arrangements.

There were no major pieces of equipment acquired during fiscal 2014. In fiscal 2013, the Company added one milling machine in its fiscal first quarter, and then added eight more machines during its fiscal third and fourth quarters. The machines were needed for new programs as well as increased capacity in its recreational powersports vehicle business. In fiscal 2013, the Company also completed a 47,000 square foot addition to its manufacturing facility that cost approximately $3.8 million. In the fiscal 2012 first quarter, the Company added two milling machines and a lathe to supplement and increase capacity in its energy business. In the Company's fiscal 2012 second quarter, another milling machine was added for increased capacity of a new program in the Company's recreational vehicle market. In the Company's fiscal 2012 third quarter, a lathe was purchased to add capacity in the energy business. In the fiscal 2012 fourth quarter, the Company implemented a robotic automation work cell for a new program and increased capacity in the recreational vehicle market. The work cell consisted of two milling machines and an automated robot.

In connection with the building addition in fiscal 2013, the Company entered into a new mortgage with its bank for $4.2 million. The mortgage carries an interest rate of 2.843%, requires monthly payments of $22,964 based on a 20 year amortization schedule and matures on May 8, 2018. The new mortgage satisfied the original mortgage of $1.1 million and provided the Company $3.1 million to use toward its building expansion project.

At February 1, 2014, the Company renewed and modified its Revolving Line of Credit with its bank. Under the agreement the Company can borrow up to $1 million. The agreement expires on February 1, 2015, is collateralized by all assets of the Company and carries an interest rate of LIBOR plus 2%. No balances were owed at August 31, 2014 and August 25, 2013 on the credit line.

The Company's total debt was $10,170,000 at August 31, 2014 which consisted of a mortgage on its building of $4,005,000 and debt secured by production equipment of $6,165,000. Current maturities of long-term debt consist of $1,453,000 due on equipment related debt and $162,000 on its building related debt. During fiscal 2014, the Company made principal payments on its debt of $1,920,000. It is management's belief that the combination of its current cash balance, its internally generated funds, as well as its revolving line of credit will be sufficient to enable the Company to meet its financial requirements during fiscal 2015.

Results of Operations: The Company experienced a sales increase of 26% in fiscal 2014 which came on top of a 5% increase in fiscal 2013. Net sales in fiscal 2014 were $42.7 million as compared to $34.0 million in fiscal 2013 and $32.5 million in fiscal 2012. The increase in fiscal 2014 came from a 45% increase in sales from recreational powersports market partially offset by a 28% decrease in the Company's energy business. The increase in the fiscal 2013 sales was driven by a 17% increase in recreational powersports vehicle market sales as well as a 32% increase in aerospace and defense sales partially offset by a 27% decrease in the Company's energy business.

11 --------------------------------------------------------------------------------The following is a reconciliation of sales by major market: Fiscal 2014 Fiscal 2013 Fiscal 2012 Recreational vehicle $ 34,244,000 $ 23,695,000 $ 20,248,000 Aerospace and defense 2,273,000 2,162,000 1,641,000 Energy 5,308,000 7,399,000 10,150,000 Biosciences & Other 889,000 709,000 417,000 $ 42,714,000 $ 33,965,000 $ 32,456,000 The increase in sales in the recreational vehicle market in both fiscal 2014 and fiscal 2013 resulted from the overall increase in demand from the Company's largest customer for the parts the Company supplies as well as new programs that had been awarded and started in both fiscal years.

Sales from the Company's aerospace and defense markets were up slightly in fiscal 2014 with growth of 5% over the prior year. The growth is not attributable to any one factor as sales to the Company's customers in these markets were mixed with some customers slightly up while others slightly down from the prior year. In fiscal 2013, sales from the Company's aerospace and defense markets were up $521,000 or 32% from fiscal 2012. The increase is primarily attributable to general increase in the level of business coming from all of the Company's aerospace and defense customers.

Sales in the Company's energy business were down 28% in fiscal 2014 as compared to the prior year. All of the Company's customers in the energy market have their own internal machining capabilities and therefore the Company's sales are generated primarily when their customers have limited machining capacity and need to outsource. This fact tends to create volatility in the Company's sales to the energy industry on top of an energy market that has volatile tendencies.

The Company's two main customers engage in providing equipment to the oil and gas shale fracturing ("fracking") sector as well as the oil field equipment industry. Sales in fiscal 2014 for both segments were down, with the decreases in the fracking business due to lower levels of demand from the Company's customer, while the oilfield segment customer decrease in the level of business appears to be related to the customer sourcing certain components to their own facilities in other countries. Sales in the Company's energy business were down 27% in fiscal 2013 as compared to fiscal 2012 for primarily the same reasons.

Sales to the Company's biosciences and other industries increased 25% in fiscal 2014 over the prior year due primarily to one-time sales to the firearms industry that will not occur in future periods. Sales in fiscal 2013 increased over 2012 due to sales from an assembly program that has had intermittent sales since fiscal 2013. However, the effect on overall Company sales is relatively small as sales from these markets only amount to approximately 1% - 3% of total sales.

The Company's gross margin increased slightly to 12.6% in fiscal 2014 from 12.3% in fiscal 2013. The Company's gross margin in fiscal 2012 was 17.8%. The fiscal 2014 increase was primarily due to efficiencies gained with volume increases offset by a higher material content of sales as well as higher fixed costs. The fiscal 2013 decrease relates to the lower level of energy business which led to excess capacity and a higher percentage of sales in fixed costs such as depreciation in that business. In fiscal 2013, the Company also experienced inefficiencies created from startups in both its recreation powersports vehicle business as well as its new firearms business.

The Company's margins can also vary widely depending on whether the Company purchases its raw material or whether raw material is provided or consigned to them by its customer. Generally, the Company will experience a higher gross margin percentage of sales where material has been consigned or provided by the customer. Therefore, in any particular quarter or year, the Company's gross margin can vary depending on the mix of parts sold and whether those parts had material that was purchased or had material that had been consigned to them.

12 --------------------------------------------------------------------------------No significant sales of obsolete items occurred in fiscal years 2012 through 2014 and, correspondingly, no significant gross margin was recognized.

Selling and administrative expense in fiscal 2014 was approximately $3,077,000, an increase of $381,000 over the fiscal 2013 amount of approximately $2,696,000.

The increase in selling and administrative expense in fiscal 2014 is mostly attributable to increased incentive compensation and profit sharing expense as well as higher payroll costs. Selling and administrative expense in fiscal 2013 decreased $464,000 from fiscal 2012. The decrease in fiscal 2013 was due primarily to decreased payroll and benefit costs due to lower incentive compensation and profit sharing expense. Included in selling and administrative cost was non-cash stock option compensation expense of $242,000, $247,000 and $198,000 in fiscal years 2014, 2013 and 2012, respectively. In addition, the Company incurred professional service expense in each of those three fiscal years in connection with its analysis of internal controls over financial reporting as required by the Sarbanes-Oxley Act.

Interest expense in fiscal 2014 increased to $410,000 from $353,000 in fiscal 2013 due to a higher average level of debt throughout the year partially offset by a lower overall interest rate level. Interest expense in fiscal 2013 increased $37,000 to $353,000 from fiscal 2012, due primarily to a higher average level of debt.

The Company recorded income taxes at an effective tax rate of 36% for fiscal years 2014, 2013 and 2012, respectively. The Company had no valuation allowance on its deferred tax assets during 2014 and 2013.

Caution Regarding Forward-Looking Statements Statements included in this Management's Discussion and Analysis of Financial Condition and Results of Operations elsewhere in this Annual Report on Form 10-K, in future filings by the Company with the Securities and Exchange Commission, in the Company's press releases and in oral statements made with the approval of an authorized executive officer which are not historical or current facts are "forward-looking statements." These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made and are not predictions of actual future results. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. These risks and uncertainties are described above under Item 1A. Risk Factors.

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