MOTORCAR PARTS OF AMERICA INC quarterly report, Q2 FY2019

Motorcar Parts of America, Inc. — Form 10-Q Summary

Business context and reporting period

Motorcar Parts of America manufactures, remanufactures, and distributes aftermarket automotive, light truck, heavy-duty truck, industrial, and agricultural parts, including rotating electrical products, wheel hubs, brake master cylinders, and diagnostic equipment. The company operates as one reportable segment and sells primarily through North American retail chains, warehouse distributors, and original-equipment service channels.

This filing covers the three and six months ended September 30, 2018, the second quarter of fiscal 2019. Comparative 2017 amounts are presented as adjusted for ASC 606 revenue recognition and revised for previously identified accounting errors.

Financial performance and position

Metric	Three months ended September 30, 2018	Three months ended September 30, 2017	Six months ended September 30, 2018	Six months ended September 30, 2017
Net sales	$127.9 million	$110.3 million	$219.6 million	$205.0 million
Gross profit	$25.7 million	$26.0 million	$42.1 million	$51.9 million
Gross margin	20.1%	23.6%	19.2%	25.3%
Operating income	$10.4 million	$12.7 million	$8.5 million	$28.3 million
Net income (loss)	$3.5 million	$5.6 million	$(2.0) million	$13.4 million
Diluted EPS	$0.18	$0.29	$(0.10)	$0.69

Second-quarter sales increased 16.0%, primarily from higher rotating electrical replenishment orders, new business, and diagnostic equipment acquired with D&V Electronics. Six-month sales increased 7.1%, while wheel hub and brake master cylinder sales remained softer.

Profitability deteriorated despite sales growth. Second-quarter gross profit declined modestly and gross margin fell 350 basis points. Six-month gross profit declined 18.9% and gross margin fell 610 basis points. Six-month operating income declined 69.8%, and the company reported a six-month net loss compared with net income in the prior-year period.

At September 30, 2018, cash and cash equivalents were $6.2 million, short-term investments were $3.2 million, and working capital was $92.6 million. Total assets were $584.0 million and shareholders’ equity was $282.2 million. Inventory, net, was $188.3 million, including a $10.0 million excess and obsolete inventory reserve, compared with $6.7 million at March 31, 2018.

Net cash used in operating activities was $6.4 million for the six months, compared with $8.1 million used in the prior-year period. Investing cash outflow was $5.5 million, including $5.3 million of capital expenditures. Financing activities provided $5.1 million. Cash declined by $6.9 million from March 31, 2018.

Debt, liquidity, and capital resources

The June 2018 amended credit facility includes a $200.0 million revolving facility and $30.0 million of term loans, maturing June 5, 2023.
Revolving borrowings were $52.9 million and term-loan principal was $30.0 million at September 30, 2018. The company reported $141.4 million of availability under the revolving facility after adjustments, with $0.7 million reserved for letters of credit.
Interest rates at September 30, 2018 were 4.66% on the revolving facility and 4.58% on the term loans.
The company was in compliance with its financial covenants: senior leverage ratio of 1.10 versus a maximum of 3.00, and fixed-charge coverage ratio of 1.29 versus a minimum of 1.10.
Receivable discount programs accelerated collection of $191.8 million of receivables during the six months and generated $7.4 million of interest expense, compared with $5.1 million in the prior-year period.
The company expects approximately $17.0 million of fiscal 2019 capital expenditures, principally for equipment and expansion in Mexico.

Material changes versus the prior comparable period

Sales growth was offset by substantially lower margins, increased operating expenses, and higher interest expense.
Second-quarter gross profit was affected by $1.8 million of Mexico transition expenses, $1.2 million of customer allowances for new business, $1.0 million of core-premium amortization, higher freight costs, and stock-adjustment accruals.
Six-month gross profit was affected by $3.6 million of Mexico transition expenses, $2.4 million of customer allowances, $2.0 million of core-premium amortization, higher freight costs, stock-adjustment accruals, and lower overhead absorption.
Non-cash revaluation write-downs for remanufactured cores held at customer locations were $6.2 million in the quarter and $8.8 million for the six months, versus $2.7 million and $4.1 million, respectively, in the prior-year periods.
Six-month general and administrative expense increased 45.4%, sales and marketing expense increased 30.3%, and research and development expense increased 57.0%, reflecting growth initiatives, Mexico expansion, D&V operations, professional fees, and share-based compensation.
Interest expense increased 61.8% in the quarter and 57.6% for the six months, driven by receivable discounting, higher borrowings and rates, and debt issuance-cost write-offs.
The company adopted ASC 606 using the full retrospective method. The adoption created substantial contract asset and contract liability balances; total contract assets were $254.7 million and total contract liabilities were $84.0 million at September 30, 2018.
The company corrected previously reported immaterial accounting errors. Management stated that the cumulative error as of June 30, 2018 understated net income by $2.9 million and that revised comparative financial statements were required for the current quarter and six-month period.

Outlook, commentary, risks, and unusual items

Management expects cash, short-term investments, receivable discount programs, available credit capacity, and other sources to fund anticipated working-capital requirements, debt repayments, lease obligations, and capital expenditures for the next 12 months. Management expects continued growth initiatives and expansion in Mexico, but the filing does not provide formal revenue or earnings guidance.

Working capital requirements remain significant because of inventory purchases to support anticipated sales and the company’s core-exchange model.
Customer concentration is high: three customers represented 85% of quarterly sales and 84% of six-month sales. The largest customer represented 39% and 38%, respectively.
Risks include customer loss or payment delays, pressure for lower prices and more favorable terms, dependence on receivable discount programs, inventory obsolescence, availability and cost of used cores, foreign exchange movements, tariffs, interest-rate increases, and covenant compliance.
The company added a specific risk concerning potential U.S. tariffs on imports from China, Canada, Mexico, and other countries, which could increase prices or reduce gross margins.
The company expects ASC 842 lease adoption in the first quarter of fiscal 2020 to significantly increase recognized long-term assets and liabilities, with an insignificant expected income-statement effect.
The board authorized $37.0 million of share repurchases; $15.7 million had been used and $21.3 million remained available at September 30, 2018. The company had repurchased and retired 675,561 shares through that date.
On December 21, 2018, the company acquired Mechanical Power Conversion LLC, operating as E&M Power. Management stated that the acquisition was not significant to consolidated results and provided no pro forma information.

Important facts for investors to verify

Reconcile reported results using the revised and ASC 606-adjusted comparative figures rather than previously filed 2017 amounts.
Assess the sustainability of sales growth against the sharp decline in gross margin and the elevated core revaluation write-downs, inventory reserves, customer allowances, and Mexico transition costs.
Monitor inventory growth, contract assets of $254.7 million, core-return assumptions, and the $10.0 million excess and obsolete inventory reserve.
Review liquidity after considering only $6.2 million of cash, $52.9 million of revolver borrowings, receivable discounting, planned capital expenditures, and required term-loan repayments.
Evaluate customer concentration and the effect of any changes in the three largest customer relationships.
Confirm continued compliance with the amended credit facility’s leverage, fixed-charge coverage, availability, repurchase, and dividend restrictions.
Track the impact of tariffs, foreign exchange, interest rates, and the company’s ability to improve margins as new business and Mexico expansion mature.
Review the disclosed accounting-error corrections and internal-control disclosures, including management’s conclusion that disclosure controls were effective as of September 30, 2018.