POWER SOLUTIONS INTERNATIONAL, INC. quarterly report, Q3 FY2015

Power Solutions International, Inc. — Q3 2015 Form 10-Q

Reporting period: Three and nine months ended September 30, 2015; filed November 9, 2015. Unaudited results. PSI designs, manufactures, distributes and supports engineered power systems and aftermarket products for industrial OEMs and on-road markets, primarily in North America. It reports one business and geographic segment.

Financial performance

Metric	Q3 2015	Q3 2014	Nine months 2015	Nine months 2014
Net sales	$112.0 million	$94.0 million	$292.8 million	$244.1 million
Gross profit / margin	$15.3 million / 13.7%	$18.6 million / 19.8%	$49.1 million / 16.8%	$46.0 million / 18.8%
Operating income	$1.4 million	$7.5 million	$9.9 million	$16.9 million
Net income	$9.1 million	$7.1 million	$12.6 million	$13.4 million
Basic / diluted EPS	$0.84 / $0.03	$0.66 / $0.56	$1.16 / $0.41	$1.26 / $1.10

• Q3 sales rose 19.2%, but acquisitions contributed approximately $19.2 million; organic sales declined about $1.2 million, mainly due to lower volume. For the nine-month period, sales rose 19.9%; about $34.1 million came from acquisitions and $14.6 million from organic growth.
• Gross profit increased 6.9% year to date, but gross margin contracted. Management cited competitive pricing and lower throughput on large custom-engineered power generation systems, production inefficiencies and higher production spending.
• Q3 net income included $8.75 million of noncash income from a reduction in the estimated fair value of private placement warrants. The EPS reconciliation removes that gain from diluted EPS, helping explain why diluted EPS was $0.03 despite basic EPS of $0.84. Nine-month warrant income was $8.04 million.
• Cash from operations was negative $22.6 million for the nine months, versus negative $13.5 million in the prior-year period. Working-capital outflows included $23.7 million used to reduce accounts payable and $10.6 million from increased receivables.
• Investing cash outflow was $42.1 million, including $34.4 million for acquisitions and $6.7 million for capital expenditures. Financing provided $70.3 million, principally from $55.0 million of Senior Notes and net revolving-credit borrowings.

Balance sheet, debt and liquidity

• At September 30, 2015, cash was $12.3 million, working capital was $155.9 million, current assets were $221.4 million and current liabilities were $65.5 million.
• Revolving-credit borrowings were approximately $99.1 million, with $13.4 million reported as unused and available under the $125 million facility. The weighted average rate on LIBOR borrowings was 1.70%. The facility is secured by substantially all tangible and intangible assets other than real property, and borrowing is subject to a borrowing base.
• PSI issued $55.0 million of unsecured 5.50% Senior Notes in April 2015, receiving $53.5 million net of transaction costs. The balance sheet reported $53.7 million of long-term debt, net. The notes mature May 1, 2018, but require an offer to repurchase in 2017 if specified EBITDA and fixed-charge coverage tests are not certified. The revolver matures between March 2017 and January 2018 under the amended terms.
• The $5.0 million term loan was repaid in April 2015. Senior Notes interest expense and higher average revolver borrowings increased interest expense; total interest expense was $3.0 million for the first nine months.
• Management stated that, based on current forecasts and assumptions, available cash and borrowing capacity should cover anticipated working capital and capital expenditures for at least the next 12 months. This depends on operating performance, customer relationships, product acceptance, development costs and future strategic transactions.

Material changes, outlook and risks

• Three acquisitions were completed in 2015: Buck’s, Bi-Phase and Powertrain. Purchase-price allocations remain provisional. Powertrain’s provisional consideration was $29.0 million, including contingent payments tied to 2015 sales; the earn-out was expected to be settled in Q1 2016. Bi-Phase also has sales-based contingent consideration. Goodwill and intangible assets increased with the acquisitions.
• 3PI, acquired in 2014, reported an operating loss of $8.0 million for the first nine months of 2015, including a $3.6 million Q3 operating loss. Management cited competitive pricing and production issues affecting custom-engineered systems.
• There is no specific earnings or revenue guidance in the filing. Management expects a modest increase in the effective interest rate from Q3 levels due to a higher revolver base rate. A one-percentage-point rate movement would change annual interest expense by approximately $991,000 based on revolver borrowings at quarter-end.
• Contingent consideration and warrant liabilities are Level 3 fair-value estimates using significant unobservable inputs. At September 30, warrant liability was $2.7 million and contingent consideration totaled $8.7 million. Changes in warrant value can materially affect reported net income and EPS without corresponding operating cash flow.
• Management cited risks including competition, customer and supplier concentration, inventory exposure, product and emissions regulation, acquisition integration, product liability and warranty claims, variable operating results, and access to capital. PSI also noted federal and state income-tax audits; it did not expect a material effect. Pending legal matters were not expected to have a material adverse effect.
• The CFO retired effective October 19, 2015, and Michael Lewis became CFO. Management reported disclosure controls effective at quarter-end; controls of the three acquired businesses were excluded from the 2015 internal-control assessment, with evaluation and implementation expected to begin in 2015 and inclusion planned for 2016.

Most important facts for investors to verify

• Whether organic sales recover and gross margins improve, particularly in custom-engineered power generation systems.
• How much reported earnings depend on noncash warrant revaluations; compare basic EPS with the diluted EPS reconciliation and operating performance.
• Whether PSI can convert earnings into operating cash and manage receivables, inventory and supplier payments.
• Revolver availability under the borrowing base, refinancing timing, and ability to meet the Senior Notes’ 2017 financial tests or repurchase requirement.
• Final acquisition valuations, acquired-business profitability, warranty reserves and contingent earn-out payments.
• Integration of acquired-company controls, the outcome of tax audits, and progress toward management’s stated liquidity outlook.