NN, Inc. — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018. Figures below are in U.S. dollars; financial statement amounts are converted from thousands to millions unless noted. The interim statements are unaudited.
Business context and reporting period
NN designs and manufactures precision components and assemblies for medical, aerospace and defense, electrical, automotive, and general industrial markets. It reported three groups: Mobile Solutions, Power Solutions, and Life Sciences. The company acquired Paragon Medical in May 2018, along with Bridgemedica, DRT Medical, and Technical Arts during 2018. The 2017 precision bearing components business was sold in August 2017 and is presented as discontinued operations.
Key financial metrics
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net sales | $205.7m | $148.2m | $571.2m | $463.7m |
| Gross margin | 24.0% | 24.9% | 24.5% | 26.6% |
| Income from operations | $5.9m | $5.6m | $9.3m | $32.0m |
| Operating margin | 2.9% | 3.7% | 1.6% | 6.9% |
| Interest expense | $18.6m | $12.7m | $46.6m | $39.9m |
| Loss from continuing operations | $(13.8)m | $(3.5)m | $(44.3)m | $(28.0)m |
| Net income (loss) | $(13.8)m | $126.0m | $(44.3)m | $112.2m |
| Basic EPS | $(0.48) | $4.57 | $(1.59) | $4.10 |
Q3 2017 net income included a $129.4m after-tax gain from the sale of the discontinued business; nine-month 2017 included $140.2m. Thus, reported net income is not a like-for-like indicator of continuing performance. 2017 comparative figures were revised for identified prior-period misstatements; management said those errors were not material to the affected prior periods.
- Revenue and segment trends: Q3 sales rose 39%, mainly from acquired businesses ($54.4m contribution), with $5.6m from higher volumes, partly offset by currency. Nine-month sales rose 23%, including $100.6m from acquisitions and $11.5m from volume. Life Sciences drove most of the acquired growth. Mobile and Power Solutions operating income declined year over year in both the quarter and year-to-date period.
- Cash flow: Nine-month operating cash flow was $(13.2)m, versus $31.3m provided in 2017. Investing cash flow was $(445.4)m, including $399.0m for acquisitions and $47.0m of capital spending. Financing cash flow was $252.8m, including $217.3m net proceeds from a September share offering. Cash declined $206.7m to $17.8m.
- Liquidity: Current assets were $354.0m and current liabilities $149.8m at September 30; working capital was $204.2m, down from $368.9m at year-end 2017. NN expected to collect $39.4m of income tax receivable substantially in Q4 2018 or Q1 2019.
- Debt: Debt principal was $893.2m, including $534.3m on the senior secured term loan, $282.0m on the incremental term loan, and $69.4m on the revolver. Cash was $17.8m. The company prepaid its $200m second-lien loan using equity-offering proceeds and repaid part of the revolver. It recorded $19.6m of nine-month debt extinguishment and issuance-cost charges, including a $4.0m prepayment penalty and $2.6m write-off related to the second-lien facility. It reported compliance with credit-facility covenants.
Changes, outlook, risks, and unusual items
- Acquisition-related sales and operating expenses expanded the business, but added amortization, integration costs, financing expense, and purchase-accounting charges. Paragon Medical contributed $70.0m of sales and $2.2m of operating income from acquisition through September 30.
- Management said cost-reduction projects generated $6.9m of nine-month cost savings, offset in part by $7.3m of inflation and wage increases. Lower pricing, product mix, launch costs, and higher depreciation weighed on segment profitability.
- No specific earnings or revenue guidance was provided. Management expected capital spending to remain relatively consistent and forecast positive cash flow from continuing operations over the next 12 months, stating available cash, revolver capacity, tax refunds, and operating cash generation should fund debt service, operations, capital spending, and dividends.
- Liquidity remains sensitive to cash generation: at quarter-end, revolver borrowing capacity was $28.2m after letters of credit and other limitations. Debt is primarily floating-rate; management estimated a 1 percentage-point rate increase would raise annual interest expense by about $8.8m across the disclosed term loans and revolver.
- Management disclosed that post-quarter market capitalization fell below the $641.0m book value of equity. A prolonged or significant decline could indicate goodwill impairment; the company planned its annual impairment test for Q4 2018. Goodwill was $624.5m.
- Disclosure controls and procedures were deemed ineffective because of previously identified material weaknesses in financial reporting, particularly staffing, income-tax accounting, and business-combination accounting. Remediation work and hiring were underway, but the weaknesses were not yet considered remediated.
- The Brazilian ICMS tax-credit dispute had a possible loss range of $0–$6.0m, no accrual, and potential indemnification from former owners. The company said other legal matters were routine and not expected to have a material adverse effect.
- Other items: the company adopted ASC 606 in 2018, with an immaterial reported impact; it expected lease accounting adoption in 2019 to add right-of-use assets and liabilities exceeding $50m each. Foreign exchange exposure was elevated and no currency derivatives or interest-rate swaps were in place.
Important facts for investors to verify
- Whether acquired businesses deliver expected growth, integration benefits, and margins, and whether preliminary purchase-price allocations change materially.
- Whether operating cash flow improves, the tax receivable is collected as expected, and available revolver capacity remains adequate.
- Debt balances, floating-rate exposure, covenant headroom, and the impact of interest-rate changes.
- Results of the Q4 goodwill impairment test, particularly given the subsequent market-capitalization decline.
- Progress and independent testing of remediation efforts for the disclosed material weaknesses and ineffective disclosure controls.
- Resolution and potential indemnification of the Brazilian tax matter, as well as the final accounting effects of the prior-period revisions.