POWER SOLUTIONS INTERNATIONAL, INC. annual report, FY2017

Power Solutions International, Inc. — FY2017 Form 10-K

Reporting period: Fiscal year ended December 31, 2017. Filed May 16, 2019, after an extended reporting delinquency; this was the company’s first regular periodic report since its filing for the quarter ended March 31, 2016. The 2015 and 2014 financial statements are restated, and the filing also addresses earlier errors and the restatement of first-quarter 2016 information.

Business context and financial results

PSI designs, manufactures and sells emission-certified engines and integrated power systems for energy, industrial and transportation markets. It reports one business segment. In 2017, 86% of sales were in North America; industrial, energy and transportation represented 46%, 38% and 16% of sales, respectively.

Metric	FY2017	FY2016
Net sales	$416.6 million	$339.5 million
Gross profit / margin	$51.0 million / 12.2%	$29.2 million / 8.6%
Operating loss	$18.0 million	$25.3 million
Net loss	$47.6 million	$47.5 million
Net loss available to common stockholders	$85.5 million	$47.5 million
Operating cash flow	$(7.7) million	$32.3 million
Capital expenditures	$5.1 million	$3.9 million

Sales rose 23%, with growth across major end markets, particularly energy and industrial. Gross margin improved 3.6 percentage points, helped by sales growth and a more favorable energy product mix, but remained constrained by manufacturing productivity issues, supply disruptions, costs not passed through to customers, and transportation-line losses. Fourth-quarter 2017 sales were $131.5 million, gross profit was $15.5 million, operating loss was $3.5 million and net loss was $6.1 million.

The common-stock loss includes a $37.9 million deemed dividend associated with the Series B preferred stock issued to Weichai; it is not an additional net loss in the income statement. Adjusted EBITDA, a non-GAAP measure, was $7.6 million, compared with $(8.4) million in 2016. It includes substantial exclusions, including restatement costs, retention and strategic-review expenses, and debt-extinguishment charges.

Financial position, debt and liquidity

• At December 31, 2017, cash was zero, current assets were $170.8 million and current liabilities were $126.7 million. Net working capital was approximately $44.1 million, largely consisting of receivables and inventory.
• Debt included $37.1 million drawn on the Wells Fargo revolving facility and $55.0 million of unsecured senior notes. The filing describes total borrowed capital as approximately $91.5 million; gross principal from these listed balances is approximately $92.1 million.
• Adjusted available borrowing capacity under the Wells Fargo facility was approximately $13 million at year-end. The notes were due January 1, 2020; the revolver’s amended maturity was November 2, 2019, creating a near-term refinancing or repayment requirement.
• Management concluded that substantial doubt existed about PSI’s ability to continue as a going concern, citing recurring losses, uncertain liquidity and uncertainty about refinancing or repaying debt. The auditor’s report also highlights this going-concern uncertainty.
• Operating cash flow turned negative from $32.3 million provided in 2016 to $7.7 million used in 2017. FY2017 financing cash flow included Weichai investment proceeds and revolving borrowings, alongside term-debt repayments.

Material changes and unusual items

• Restatement: Restatement adjustments reduced 2015 stockholders’ equity by $21.4 million and 2014 equity by $4.3 million. Previously reported net income was reduced by $17.2 million for 2015, converting it to a $2.9 million net loss, and by $2.2 million for 2014. Issues included revenue recognition, product-development cost capitalization, inventory valuation, impairments, warranty accruals and other accounting matters. Investors are directed to rely on the financial information in this filing rather than prior reports for the affected periods.
• Weichai financing and control: Weichai invested $60 million in 2017, strengthening PSI’s capital position and helping fund repayment of a high-cost $60 million TPG term loan. PSI recorded an $11.9 million debt-extinguishment loss, principally from unamortized financing costs, and a $4.0 million noncash loss from the Weichai warrant’s fair-value change. Weichai exercised the warrant in April 2019 and became the majority shareholder, with 51.5% ownership.
• Restatement-related expenses: FY2017 operating results included $19.0 million of restatement, strategic/financing review and employee-retention-related expenses; $13.3 million was restatement-related professional services. The filing reports $16.8 million of cumulative audit, legal and consulting costs incurred through year-end 2017 for the restatement and related activities.
• Shareholder accounting impact: In addition to the $47.6 million net loss, the $37.9 million deemed preferred-stock dividend raised the loss attributable to common stockholders to $85.5 million, or $6.20 per share.
• Legal matters: PSI accrued an $8.5 million securities-litigation settlement, with a corresponding insurance recovery recorded. A separate derivative-litigation settlement of approximately $1.9 million was pending court approval as of the filing; the company also disclosed ongoing SEC and U.S. Attorney investigations, with outcomes not predictable.

Outlook, management commentary and principal risks

Management reported unaudited 2018 sales of approximately $500 million, with growth across all end markets, led by transportation and energy. It expected significant 2018 professional fees related to the restatement, audits, investigations and control remediation, as well as continued product-development spending. The company also expected significant net losses for 2018. These are management statements, not a formal earnings guidance range.

Management’s operating priorities include improving margins through pricing, product redesign, sourcing and manufacturing efficiency; tightening spending and working-capital controls; upgrading business systems; and expanding higher-margin heavy-duty energy engines. PSI reported receiving EPA certification for its 32-liter and 40-liter heavy-duty engines in 2018. The filing cautions that product launches, margin improvements and market opportunities may not deliver expected results.

• Management found disclosure controls and internal control over financial reporting ineffective as of December 31, 2017, with multiple material weaknesses involving the control environment, accounting expertise, revenue recognition, reserves, period-end close, IT controls, data integrity and complex transactions. Remediation was underway and not complete.
• PSI was cooperating with SEC and criminal investigations. Potential sanctions, litigation costs, indemnification obligations and insurance limitations could materially affect its financial condition or cash flows.
• Debt covenants, limited borrowing availability, refinancing needs and dependence on lender waivers heighten liquidity and going-concern risk. The filing also describes reporting-related defaults or waivers and a May 2019 waiver allowing delivery of FY2018 audited statements by December 31, 2019.
• Other material business risks include customer and supplier concentration, manufacturing and warranty performance, emissions compliance, fuel-price volatility, tariffs and foreign sourcing, competition, and the possibility that new products or alternative-fuel markets fail to meet expectations.
• The stock was delisted from Nasdaq in April 2017 and traded on the OTC market. Weichai’s majority ownership gives it voting control and may limit other shareholders’ influence.

Important facts for investors to verify

• Whether PSI completed subsequent filings and remediated the disclosed material weaknesses, and whether later audits identified additional issues.
• Current cash, revolver availability, covenant compliance and the status and terms of refinancing or repayment of the notes and credit facility.
• Actual audited results for 2018 and later periods, including whether the reported approximately $500 million 2018 sales estimate translated into improved margins, cash flow and profitability.
• Final outcomes and insurance coverage for the SEC and USAO investigations, securities and derivative litigation, and other disclosed legal claims.
• The realized costs and operating benefits of the Weichai relationship, the consequences of its majority control, and any dilution or tax attributes affected by the 2019 warrant exercise.