LGL

Business Context and Reporting Period

Company: The LGL Group, Inc. (LGL)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2008
Business Overview: LGL is a holding company operating primarily through its subsidiary, M-tron Industries, Inc. (MtronPTI). The company manufactures custom-designed, highly engineered frequency control devices (quartz crystals, oscillators, and electronic filters) used in telecommunications, military, avionics, and industrial applications. Operations are located in Orlando, Florida; Yankton, South Dakota; Noida, India; and a sales office in Hong Kong.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Revenues increased 1.6% to $40.2 million, driven by a $365,000 increase in foreign sales and a $278,000 increase in domestic sales.
• Operating Loss Improvement: The operating loss narrowed by $882,000 compared to 2007. This improvement was largely due to a $905,000 impairment charge on Lynch Systems assets recognized in 2007, which did not recur in 2008.
• Expense Increases: Engineering, selling, and administrative expenses rose by $228,000 to $11.2 million. This was driven by increased product development costs (more engineering personnel) and higher corporate costs, including a $400,000 increase in professional fees related to financial statement restatements and Sarbanes-Oxley compliance.
• Investment Income Decline: Investment income dropped to $0 from $1.5 million in 2007 due to the sale of marketable securities in the first quarter of 2007.
• Backlog Reduction: Order backlog decreased significantly from $10.9 million in 2007 to $7.5 million in 2008, reflecting customer order cancellations and deferrals.

Guidance, Outlook, Risks, and Unusual Items

Management Commentary and Outlook

Management expects to fill the 2008 backlog in 2009. The company anticipates continued pressure on margins due to market conditions and raw material costs. While the company has been able to pass some cost increases to customers, revenues and margins have been adversely impacted. The company is focused on reducing manufacturing cycle times and expanding its offering of integrated timing systems.

Liquidity and Capital Resources

The company reported a net loss of $1.3 million and used $861,000 in cash for operating activities. However, it maintained a positive working capital position of $9.7 million. The company relies on a revolving credit facility (maturing June 30, 2009) and a term loan (maturing 2010/2013). As of March 27, 2009, $1.5 million was outstanding on the revolver. Management believes it has sufficient cash to pay the revolver balance upon maturity if not renewed, but notes that obtaining new financing in the current economic environment may be difficult.

Risks and Contingencies

• Internal Control Weakness: Management concluded that disclosure controls and internal controls over financial reporting were not effective as of December 31, 2008, due to a material weakness in information technology applications and infrastructure (specifically system change management and logical access controls). Remediation is expected to take 3-4 months.
• Profitability Uncertainty: The company reported operating losses in both 2007 and 2008 and stated uncertainty regarding when or if it will return to profitability.
• Customer Concentration: The top 10 customers accounted for 47% of revenues in 2008 (down from 64.7% in 2007). The two largest customers accounted for 12.9% of total consolidated revenues.
• Contract Manufacturer Reliance: Approximately 12.7% of 2008 revenue was attributable to a single contract manufacturer in Korea/China. There is no long-term written supply contract with this vendor.
• Discontinued Operations: The company sold the operating assets of Lynch Systems in 2007. Remaining assets (land and buildings) are being marketed for sale. Discontinued operations generated a small income of $24,000 in 2008.

Investor Verification Checklist

• Internal Control Remediation: Verify the timeline and progress of the plan to remediate the material weakness in IT controls and financial reporting.
• Debt Renewal: Confirm the status of the revolving credit facility maturing June 30, 2009, and the company's ability to refinance or repay the $1.5 million outstanding balance.
• Profitability Path: Assess the specific operational changes required to reverse the trend of operating losses, given the lack of a clear timeline for return to profitability.
• Backlog Quality: Evaluate the risk of further order cancellations given the 31% decline in backlog and the company's admission that customers can cancel with little penalty.
• Restatement Impact: Review the details of the 2007 and prior year financial restatements that drove the $400,000 increase in professional fees.