The Eastern Company — Q3 2017 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2017; comparisons are to the quarter and nine months ended October 1, 2016. Results are unaudited. The period includes Velvac from its April 3, 2017 acquisition, so reported growth is not wholly organic.
Financial performance
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Net sales | $56.0 million | $33.5 million | $150.1 million | $103.5 million |
| Gross margin | $11.9 million; 21.3% | $9.4 million; 28.0% | $36.2 million; 24.1% | $25.5 million; 24.6% |
| Operating profit | $3.6 million | $3.3 million | $8.3 million | $7.3 million |
| Net income | $2.2 million | $2.4 million | $5.2 million | $5.1 million |
| Diluted EPS | $0.35 | $0.38 | $0.83 | $0.82 |
| Operating cash flow | Not separately stated for the quarter | $10.2 million | $9.0 million |
Q3 sales rose 67.3% and nine-month sales rose 45.1%. Q3 net income fell about 7%; nine-month net income increased about 1.5%. Interest expense was $0.3 million for Q3 and $0.7 million for nine months, compared with $0.03 million and $0.1 million, respectively, a result management attributed to acquisition-related borrowing. The effective tax rate was 32% in both 2017 periods, versus 26% for Q3 2016 and 30% for the 2016 nine-month period.
Balance sheet and liquidity
- At September 30, 2017, cash and cash equivalents were $21.2 million, marketable securities $0.4 million, current assets $99.6 million and current liabilities $31.5 million. Working capital was approximately $68.0 million; the current ratio was 3.1, down from 5.7 at Q3 2016 and 6.0 at year-end 2016.
- Total debt was approximately $35.6 million, comprising $6.6 million current and $29.1 million long-term debt. Cash less debt was approximately negative $14.4 million. Debt-to-equity was 40.6%, versus 2.6% at Q3 2016.
- The company generated $10.2 million of operating cash flow but used $44.0 million in investing activities, primarily for the Velvac acquisition. Financing provided $31.8 million. Cash declined $1.5 million from year-end 2016.
- Cash included $14.1 million held by a foreign subsidiary; management said foreign earnings are intended to remain invested abroad indefinitely. The $10 million revolving facility had $5 million drawn at quarter-end. The company reported compliance with its loan covenants.
- Inventories were $45.2 million, up from $34.0 million at year-end 2016; accounts receivable were $28.4 million, up from $18.1 million. The filing attributes much of the increases to Velvac.
Changes, acquisition and management commentary
- Velvac, a supplier of vision technology for commercial vehicles and motorhomes, was acquired April 3 for stated purchase price of $39.5 million, plus contingent earnout consideration. Acquisition funding included a $31 million term loan, a $5 million revolver draw and cash. The purchase-accounting table records total consideration of $42.148 million, including $36 million debt, $4.078 million cash and $2.070 million contingent consideration.
- Industrial Hardware Q3 sales increased 117%, primarily from Velvac; excluding Velvac, management said the segment increased 12%. Security Products sales rose 18% and Metal Products sales rose 50%. For the first nine months, management reported Industrial Hardware growth of 83% (13% excluding Velvac), Security Products growth of 6%, and Metal Products growth of 45%.
- Q3 gross margin fell to 21.3% from 28.0%; management attributed the decline mainly to Velvac and said it would have been 24% excluding Velvac. The acquisition also produced an $11.8 million inventory fair-value step-up, fully charged to cost of sales in Q2. Management cited a separate $1.2 million purchase-accounting charge affecting Industrial Hardware gross margin.
- Engineering expense rose $1.2 million in Q3 and $2.2 million for nine months, principally for Road-iQ technology development and Greenwald’s gPay payment app. Management expected these products to be ready for market later in Q4 2017.
- Management said raw-material prices had increased and were expected to rise further in Q4; the company seeks to recover increases through pricing and cost reductions. It reported no indication of supply shortages. Management expected cash, operating cash flow and available revolver funds to cover foreseeable working-capital needs. Full-year 2017 capital expenditures were expected to be about $3.0 million.
- One-time or unusual costs included $0.9 million of acquisition expenses for nine months, $0.4 million for personnel and environmental items cited in MD&A, and a $0.38 million charge for remediation and monitoring of a New York landfill. The filing says the remediation plan was under final negotiation with the state regulator. A separate Illinois site remediation system was under review, with estimated cost of about $55,000.
- The company changed its pension-cost measurement method prospectively; management estimated this reduced nine-month 2017 pension and postretirement expense by approximately $406,000. The filing identifies forward-looking risks including customer preferences, new-product success, customer loss, competition, raw-material costs, foreign sourcing, industry and economic conditions, and litigation or legislation. It reported no material change to the risk factors in its 2016 Form 10-K.
Important facts for investors to verify
- How much of reported revenue and earnings growth is sustainable and organic after separating Velvac’s contribution.
- Whether acquired-product margins improve after the inventory fair-value charge and whether overall gross margins recover.
- Velvac’s performance against earnout conditions, the potential future earnout obligation, and the acquisition’s contribution to cash flow and debt repayment.
- Liquidity and covenant headroom as debt service increases; the filing does not provide a clear numerical covenant cushion.
- Inventory and receivables growth, raw-material cost trends, and the timing and final cost of environmental remediation.