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TRANSCAT INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
[November 10, 2014]

TRANSCAT INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements. This report contains "forward-looking statements" as defined by the Private Securities Litigation Reform Act of 1995. These statements relate to expectations, estimates, beliefs, assumptions and predictions of future events and are identified by words such as "anticipates," "believes," "estimates," "expects," "projects," "intends," "could," "may" and other similar words. Forward-looking statements are not statements of historical fact and thus are subject to risks, uncertainties and other factors that could cause actual results to differ materially from historical results or those expressed in such forward-looking statements. You should evaluate forward-looking statements in light of important risk factors and uncertainties that may affect our operating and financial results and our ability to achieve our financial objectives. These factors include, but are not limited to, our reliance on one vendor to supply a significant amount of inventory purchases, the risks related to current and future indebtedness, the relatively low trading volume of our common stock, risks related to our acquisition strategy and the integration of the businesses we acquire, the impact of economic conditions, the highly-competitive nature of our two business segments, and cybersecurity risks.



These risk factors and uncertainties are more fully described by us under the heading "Risk Factors" in our reports filed with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the fiscal year ended March 29, 2014. You should not place undue reliance on our forward-looking statements. Except as required by law, we undertake no obligation to update or publicly announce any revisions to any of the forward-looking statements contained in this report, whether as a result of new information, future events or otherwise.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES There have been no material changes to our critical accounting policies and estimates from the information provided in our Annual Report on Form 10-K for the fiscal year ended March 29, 2014.


RESULTS OF OPERATIONS The following table presents, for the second quarter and first six months of fiscal years 2015 and 2014, the components of our Consolidated Statements of Income: (Unaudited) (Unaudited) Second Quarter Ended Six Months Ended September 27, September 28, September 27, September 28, 2014 2013 2014 2013 Gross Profit Percentage: Distribution Gross Profit 19.7 % 23.6 % 20.8 % 23.6 % Service Gross Profit 26.0 % 23.6 % 25.1 % 25.4 % Total Gross Profit 22.3 % 23.6 % 22.6 % 24.4 % As a Percentage of Total Revenue: Distribution Sales 59.5 % 60.3 % 58.9 % 59.7 % Service Revenue 40.5 % 39.7 % 41.1 % 40.3 % Total Revenue 100.0 % 100.0 % 100.0 % 100.0 %Selling, Marketing and Warehouse Expenses 10.2 % 11.4 % 11.5 % 12.1 % Administrative Expenses 7.2 % 7.8 % 7.3 % 8.1 % Total Operating Expenses 17.4 % 19.2 % 18.8 % 20.2 % Operating Income 4.9 % 4.4 % 3.8 % 4.2 %Interest and Other Expense, net 0.5 % 0.2 % 0.3 % 0.1 % Income Before Income Taxes 4.4 % 4.2 % 3.5 % 4.1 % Provision for Income Taxes 1.6 % 1.5 % 1.3 % 1.5 % Net Income 2.8 % 2.7 % 2.2 % 2.6 % 11 SECOND QUARTER ENDED SEPTEMBER 27, 2014 COMPARED TO SECOND QUARTER ENDED SEPTEMBER 28, 2013 (dollars in thousands): Revenue: Second Quarter Ended September 27, September 28, Change 2014 2013 $ % Revenue: Service $ 12,595 $ 11,472 $ 1,123 9.8 % Distribution 18,516 17,410 1,106 6.4 % Total $ 31,111 $ 28,882 $ 2,229 7.7 % Total revenue increased $2.2 million, or 7.7%, from the second quarter of fiscal year 2014 to the second quarter of fiscal year 2015.

Service revenue increased $1.1 million, or 9.8%, from the second quarter of fiscal year 2014 to the second quarter of fiscal year 2015. This year-over-year growth is primarily the result of the retention of revenue from existing customers as well as customer base expansion, which we achieved through business development activities.

Our fiscal years 2015 and 2014 Service revenue growth, in relation to prior fiscal year quarter comparisons, was as follows: FY 2015 FY 2014 Q2 Q1 Q4 Q3 Q2 Q1 Service Revenue Growth 9.8 % 3.4 % 10.3 % 16.5 % 16.6 % 34.4 % Within any quarter, while we add new customers, we also have customers from the prior year whose service orders may not repeat for any number of reasons. Among those reasons are variations in the timing of periodic calibrations and other services, customer capital expenditures and customer outsourcing decisions.

Because the timing of Service segment orders can vary on a quarter-to-quarter basis, we believe a trailing twelve-month trend provides a better indication of the long-term progress of this segment. The following table presents the trailing twelve-month Service segment revenue for each quarter in fiscal years 2015 and 2014 as well as the trailing twelve-month revenue growth as a comparison to that of the prior fiscal year period: FY 2015 FY 2014 Q2 Q1 Q4 Q3 Q2 Q1 Trailing Twelve-Month: Service Revenue $ 49,706 $ 48,583 $ 48,184 $ 46,926 $ 45,294 $ 43,662 Service Revenue Growth 9.7 % 11.3 % 18.5 % 19.9 % 18.1 % 18.9 % Within the calibration industry, there is a broad array of measurement disciplines making it costly and inefficient for any one provider to invest the needed capital for the facilities, equipment and uniquely trained personnel necessary to address all measurement disciplines with in-house calibration capabilities. Our strategy has been to focus our investments in the core electrical, temperature, pressure and dimensional disciplines. Accordingly, over the long-term, we expect to outsource 10% to 20% of Service revenue to third party vendors for calibration beyond our chosen scope of capabilities. During any individual quarter, we could fluctuate beyond these percentages. We continually evaluate our outsourcing needs and make capital investments, as deemed necessary, to add more in-house capabilities and reduce the need for third party vendors. The following table presents the sources of our Service revenue and the percentage of Service revenue derived from each source for each quarter of fiscal years 2015 and 2014: FY 2015 FY 2014 Q2 Q1 Q4 Q3 Q2 Q1 Percent of Service Revenue: In-House 81.6 % 82.8 % 83.4 % 82.7 % 81.9 % 83.7 % Outsourced 16.5 % 15.1 % 14.5 % 15.3 % 15.9 % 14.2 % Freight Billed to Customers 1.9 % 2.1 % 2.1 % 2.0 % 2.2 % 2.1 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 12 Our Distribution sales accounted for 59.5% of our total revenue in the second quarter of fiscal year 2015 and 60.3% of our total revenue in the second quarter of fiscal year 2014. Distribution sales in the second quarter of fiscal year 2015 were $18.5 million, a 6.4% improvement over the second quarter of fiscal year 2014. We attribute this growth to competitive pricing strategies used to gain volume and market share. Our fiscal years 2015 and 2014 Distribution sales growth (decline), in relation to prior fiscal year quarter comparisons, wasas follows: FY 2015 FY 2014 Q2 Q1 Q4 Q3 Q2 Q1 Distribution Sales Growth (Decline) 6.4 % 0.1 % (10.3 %) (2.3 %) 2.7 % 3.7 % Distribution sales in any given period may vary based on the number of business days within that period. To normalize this variability, we review Distribution sales on a per business day basis when comparing sales in two or more periods.

Our Distribution sales per business day for each quarter during fiscal years 2015 and 2014 were as follows: FY 2015 FY 2014 Q2 Q1 Q4 Q3 Q2 Q1Distribution Sales Per Business Day $ 299 $ 265 $ 265 $ 311 $ 281 $ 265 Distribution orders include orders for instruments that we routinely stock in our inventory, customized products, and other products ordered less frequently, which we do not stock. Pending product shipments are primarily backorders, but also include products that are requested to be calibrated in our service centers prior to shipment, orders required to be shipped complete or at a future date, and other orders awaiting final credit or management review prior to shipment.

Variations in pending product shipments can be impacted by several factors, including the timing of when product orders are placed in relation to the end of the fiscal period, specialized product orders that are not stocked, or production issues experienced by manufacturers. Our total pending product shipments at the end of the second quarter of fiscal year 2015 remained relatively consistent with the second quarter of fiscal year 2014. The following table presents our historical trend of total pending product shipments and the percentage of total pending product shipments that were backorders at the end of each quarter of fiscal years 2015 and 2014: FY 2015 FY 2014 Q2 Q1 Q4 Q3 Q2 Q1 Total Pending Product Shipments $ 3,383 $ 2,860 $ 2,455 $ 2,861 $ 3,438 $ 3,433 % of Pending Product Shipments that were Backorders 69.0 % 64.1 % 69.1 % 71.2 % 63.8 % 68.7 % Gross Profit: Second Quarter Ended September 27, September 28, Change 2014 2013 $ % Gross Profit: Service $ 3,272 $ 2,708 $ 564 20.8 % Distribution 3,654 4,113 (459 ) (11.2 %) Total $ 6,926 $ 6,821 $ 105 1.5 % Total gross profit in the second quarter of fiscal year 2015 increased $0.1 million, or 1.5%, from the second quarter of fiscal year 2014. Total gross margin in the second quarter of fiscal year 2015 decreased 130 basis points from the second quarter of fiscal year 2014.

13 Service gross profit in the second quarter of fiscal year 2015 increased $0.6 million, or 20.8%, from the second quarter of fiscal year 2014. Service gross margin increased 240 basis points over the same quarter of the prior fiscal year to 26.0%. In general, our Service revenue growth provides incremental gross margin growth due to the operating leverage achieved through our relatively fixed cost structure in this segment. The following table presents the quarterly historical trend of our Service gross margin as a percent of Service revenue: FY 2015 FY 2014 Q2 Q1 Q4 Q3 Q2 Q1 Service Gross Margin 26.0 % 24.2 % 31.4 % 23.4 % 23.6 % 27.2 % We evaluate Distribution gross profit from two perspectives. Channel gross profit includes net sales less the direct cost of inventory sold. Our Distribution gross profit includes channel gross profit as well as the impact of vendor rebates, cooperative advertising income, freight billed to customers, freight expenses and direct shipping costs. In general, our Distribution gross margin can vary based upon the mix of products sold, price discounting and the timing of periodic vendor rebates and cooperative advertising income received from suppliers.

Distribution gross profit was $3.7 million in the second quarter of fiscal year 2015, a $0.5 million decline when compared to the second quarter of fiscal year 2014. As a percent of Distribution sales, Distribution gross margin declined to 19.7% in the second quarter of fiscal year 2015 compared with 23.6% in the second quarter of fiscal year 2014. The decrease in gross margin reflects increased price discounts extended to customers and lower vendor rebates. The following table reflects the quarterly historical trend of our Distribution gross margin as a percent of Distribution sales: FY 2015 FY 2014 Q2 Q1 Q4 Q3 Q2 Q1 Channel Gross Margin (1) 19.8 % 19.5 % 20.4 % 19.7 % 20.2 % 20.5 % Total Distribution Gross Margin (2) 19.7 % 22.0 % 25.9 % 23.4 % 23.6 % 23.7 % (1) Channel gross margin is calculated as net sales less purchase costs divided by net sales.

(2) Includes vendor rebates, cooperative advertising income, freight billed to customers, freight expenses, and direct shipping costs.

Operating Expenses: Second Quarter Ended September 27, September 28, Change 2014 2013 $ % Operating Expenses:Selling, Marketing and Warehouse $ 3,169 $ 3,295 $(126 ) (3.8 %) Administrative 2,241 2,245 (4 ) (0.2 %) Total $ 5,410 $ 5,540 $ (130 ) (2.3 %) Operating expenses decreased $0.1 million, or 2.3%, from the second quarter of fiscal year 2014 to the second quarter of fiscal year 2015. The decrease was primarily due to decreased selling expenses. As a percentage of total revenue, operating expenses were 17.4% and 19.2% in the second quarter of fiscal years 2015 and 2014, respectively.

Taxes: Second Quarter Ended September 27, September 28, Change 2014 2013 $ % Provision for Income Taxes $ 519 $ 442 $ 77 17.4 % Our effective tax rates for the second quarter of fiscal years 2015 and 2014 were 37.7% and 36.4%, respectively. We continue to evaluate our tax provision on a quarterly basis and make adjustments, as deemed necessary, to our effective tax rate given changes in facts and circumstances expected for the entire fiscal year.

14 SIX MONTHS ENDED SEPTEMBER 27, 2014 COMPARED TO SIX MONTHS ENDED SEPTEMBER 28, 2013 (dollars in thousands): Revenue: Six Months Ended September 27, September 28, Change 2014 2013 $ % Revenue: Service $ 24,733 $ 23,211 $ 1,522 6.6 % Distribution 35,497 34,381 1,116 3.2 % Total $ 60,230 $ 57,592 $ 2,638 4.6 % Total revenue increased $2.6 million, or 4.6%, from the first six months of fiscal year 2014 to the first six months of fiscal year 2015.

Service revenue increased $1.5 million, or 6.6%, from the first six months of fiscal year 2014 to the first six months of fiscal year 2015. The growth is attributed primarily to higher organic revenue driven by retention and expansion of our customer base through business development activities.

Our Distribution sales accounted for 58.9% and 59.7% of our total revenue in the first six months of fiscal years 2015 and 2014, respectively. For the first six months of fiscal year 2015, Distribution sales increased $1.1 million, or 3.2%, compared with the first six months of fiscal year 2014.

Gross Profit: Six Months Ended September 27, September 28, Change 2014 2013 $ % Gross Profit: Service $ 6,209 $ 5,904 $ 305 5.2 % Distribution 7,386 8,131 (745 ) (9.2 %) Total $ 13,595 $ 14,035 $ (440 ) (3.1 %) Total gross profit in the first six months of fiscal year 2015 decreased $0.4 million, or 3.1%, from the first six months of fiscal year 2014. Total gross margin decreased 180 basis points to 22.6% of total revenue in the first six months of fiscal year 2015 compared with 24.4% in the first six months of fiscal year 2014. The year-over-year reduction in gross margin was primarily due to lower Distribution segment vendor rebates which accounted for 170 basis points of the decline.

Service segment gross profit increased $0.3 million, or 5.2%, from the first six months of fiscal year 2014 to the first six months of fiscal year 2015. Service segment gross margin decreased 30 basis points over the same time period inthe prior fiscal year to 25.1%.

Distribution segment gross profit decreased $0.7 million in the first six months of fiscal year 2015 to $7.4 million. Distribution segment gross margin decreased 280 basis points to 20.8% in the first six months of fiscal year 2015 compared to 23.6% in the first six months of fiscal year 2014. This decrease is primarily due to lower vendor rebates.

Operating Expenses: Six Months Ended September 27, September 28, Change 2014 2013 $ % Operating Expenses: Selling, Marketing and Warehouse $ 6,904 $ 6,996 $ (92 ) (1.3 %) Administrative 4,416 4,606 (190 ) (4.1 %) Total $ 11,320 $ 11,602 $ (282 ) (2.4 %) Operating expenses for the first six months of fiscal year 2015 were $11.3 million, a decrease of 2.4% from the first six months of fiscal year 2014. The decrease was primarily due to decreased administrative expenses resulting from lower employee-related expenses. As a percentage of total revenue, operating expenses during the first six months of fiscal year 2015 were 18.8%, compared to 20.2% in the first six months of fiscal year 2014.

15 Taxes: Six Months Ended September 27, September 28, Change 2014 2013 $ %Provision for Income Taxes $ 788 $ 869 $ (81 ) (9.3 )% Our effective tax rates for the first six months of fiscal years 2015 and 2014 were 37.7% and 36.8%, respectively. We continue to evaluate our tax provision on a quarterly basis and make adjustments, as deemed necessary, to our effective tax rate given changes in facts and circumstances expected for the entire fiscal year.

LIQUIDITY AND CAPITAL RESOURCES Through our credit agreement (the "Credit Agreement"), we have a revolving credit facility (the "Revolving Credit Facility"). Effective August 26, 2014, we entered into an amendment (the "Amendment") to the Credit Agreement. The Amendment increased the maximum amount of the Revolving Credit Facility from $20.0 million to $30.0 million, increased the amount of borrowings that may be used for business acquisitions from $10.0 million per fiscal year to $15.0 million per fiscal year and extended the maturity date to September 20, 2018.

All other material terms and conditions of the Credit Agreement remain unchanged.

As of September 27, 2014, $27.1 million was available under the Revolving Credit Facility, of which $16.3 million was outstanding and included in long-term debt on the Consolidated Balance Sheet. During the first six months of fiscal year 2015, $6.7 million of the $15.0 million of borrowings available for business acquisitions in fiscal year 2015 was utilized, leaving $8.3 million available for the remainder of the fiscal year.

The Credit Agreement has certain covenants with which we have to comply, including a fixed charge ratio covenant and a leverage ratio covenant. We were in compliance with all loan covenants and requirements throughout the firstsix months of fiscal year 2015.

We believe that amounts available under our current credit facility and our cash on hand are sufficient to satisfy our expected working capital and capital expenditure needs as well as our lease commitments for the foreseeable future.

Cash Flows: The following table is a summary of our Consolidated Statements of Cash Flows (dollars in thousands): Six Months Ended September 27, September 28, 2014 2013 Cash (Used in) Provided by: Operating Activities $ (411 ) $ 234 Investing Activities (8,513 ) (313 ) Financing Activities 8,990 32 Operating Activities: Net cash used in operating activities was $0.4 million in the first six months of fiscal year 2015 compared to $0.2 million net cash provided by operating activities in first six months of fiscal year 2014.

Significant working capital fluctuations in fiscal year 2015 were as follows: · Inventory/Accounts Payable: Our inventory balance at September 27, 2014 was $7.5 million, up from $6.2 million at March 29, 2014. Our inventory strategy includes making appropriate large quantity, high dollar purchases with key manufacturers for various reasons, including maximizing on-hand availability of key products, reducing backorders for those products with long lead times and optimizing vendor volume discounts. As a result, inventory levels from quarter-to-quarter will vary based on the timing of these large orders in relation to the quarter-end. In general, our accounts payable balance increases or decreases as a result of timing of vendor payments for inventory receipts. However, this correlation may vary at a quarter-end due to the timing of vendor payments for inventory received and inventory shipped directly to customers, as well as the timing of Distribution sales.

· Receivables: Our days sales outstanding continue to reflect strong collections. Days sales outstanding for the six months ended September 27, 2014 increased to 43 days from 40 days in the comparable period of the prior fiscal year. This increase reflects the impact of extended payment terms offered by recently acquired companies. The following table illustrates our days sales outstanding for the fiscal quarters ended September 27, 2014 and September 28, 2013: September 27, September 28, 2014 2013 Net Sales, for the last two fiscal months $ 22,776 $ 21,043 Accounts Receivable, net $ 16,345 $ 13,933 Days Sales Outstanding 43 40 16 · Accrued Compensation and Other Liabilities: Accrued Compensation and Other Liabilities include, among other things, amounts to be paid to employees for performance-based incentive plans. At the end of any particular period, the amounts accrued for such incentive plans may vary due to many factors including, but not limited to, changes in expected performance levels, the performance measurement period, and timing of payments to employees. During the first six months of fiscal year 2015, we used $2.1 million in cash primarily to make annual incentive plan payments compared with $1.0 million in the first six months of 2014.

Investing Activities: During the first six months of fiscal year 2015, we invested $6.7 million in a business acquisition and $1.9 million in capital expenditures. Net cash used for investing activities during the first six months of fiscal year 2014 consisted of $0.6 million for capital expenditures, offset by $0.2 million of proceeds from the sale of property and equipment. The capital expenditures in both fiscal periods were primarily for additional Service segment capabilities and information technology improvements, including our new state-of-the-art C3 Metrology Management Software.

Financing Activities: During the first six months of fiscal year 2015, financing activities provided approximately $9.0 million of net cash, primarily from our Revolving Credit Facility, which was used to pay for a business acquisition and to make annual performance-based incentive plan payments. During the first six months of fiscal year 2014, net cash provided by financing activities was less than $0.1 million and included $0.7 million from our revolving line of credit and $0.1 million from the issuance of common stock, offset by the use of $0.8 million to repurchase 0.1 million shares of our common stock.

OUTLOOK We expect continued strength in our Service segment and believe our market leadership positions across both of our segments, along with strategic business acquisitions, will continue to foster meaningful growth. On a consolidated basis, we expect to achieve strong operating income growth for the fiscal year.

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