The Eastern Company: Q2 2017 Form 10-Q
Business context and reporting period
The filing covers the 13 weeks and six months ended July 1, 2017. Eastern operates Industrial Hardware, Security Products, and Metal Products segments. On April 3, 2017, it acquired Velvac, a designer and manufacturer of vision technology for commercial vehicles, for $39.5 million plus contingent earnout consideration.
Financial performance
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Net sales | $58.0 million | $36.9 million | $94.1 million | $70.0 million |
| Gross margin | $14.0 million (24.1%) | $8.6 million (23.3%) | $22.3 million (23.7%) | $15.0 million (21.5%) |
| Operating profit | $2.5 million | $3.1 million | $4.7 million | $4.1 million |
| Net income | $1.5 million | $2.1 million | $3.0 million | $2.7 million |
| Diluted EPS | $0.23 | $0.33 | $0.47 | $0.44 |
| Operating cash flow | Not separately reported for Q2 | $6.3 million | $6.1 million |
Second-quarter sales rose 57.4%, primarily reflecting Velvac; excluding Velvac, Industrial Hardware sales rose 21%. First-half sales increased 34.4%. Q2 gross margin improved, but operating profit and net income declined as selling and administrative expenses rose 109.5% and interest expense increased following acquisition borrowing. First-half net income rose 9.1%.
At July 1, cash and cash equivalents were $19.1 million, working capital was $66.3 million, and the current ratio was 3.2. Total debt was approximately $36.0 million, comprising $6.55 million current and $29.45 million long-term. Shareholders’ equity was $85.4 million. Cash decreased $3.65 million in the first half: operating cash flow of $6.31 million and financing inflows of $32.84 million were outweighed by investing outflows of $43.17 million, mainly the Velvac acquisition.
Material changes and unusual items
- Industrial Hardware sales increased 121% in Q2, including Velvac; Security Products sales rose 2%, and Metal Products sales rose 32%. Higher mining demand and improved production utilization supported Metal Products margins.
- The acquisition added $17.5 million of goodwill and $11.56 million of identifiable intangible assets. A $1.19 million acquired-inventory fair-value step-up was charged to cost of sales in Q2.
- Q2 selling and administrative expenses included $691,000 of acquisition costs; first-half acquisition costs were $869,000. Management also cited $0.2 million of personnel-change costs and $0.3 million of environmental costs.
- Management changed its pension and postretirement service-cost and interest-cost measurement method prospectively; it reduced first-half 2017 benefit expense by approximately $270,000 versus the prior method.
Outlook, risks, and contingencies
Management expects 2017 capital expenditures of approximately $3.0 million, with about $200,000 of commitments outstanding at quarter-end. Raw-material prices were slightly higher than in 2016 and were expected to remain flat to slightly higher in the second half; the company said it may seek to recover increases through pricing. Management expected cash, operating cash flow, and available revolver capacity to cover foreseeable working-capital needs and obligations.
The $31 million term loan and $10 million revolving facility bear variable rates; $15.5 million of term debt was hedged with an interest-rate swap. The company had drawn $5 million on the revolver at quarter-end and reported compliance with loan covenants. Covenants restrict, among other things, additional debt, dividends, and asset dispositions; a default could accelerate repayment. The Velvac earnout had a reported fair value of $2.07 million and depends on EBITDA targets and Road-iQ sales. Risks include acquisition integration and realization of anticipated benefits, customer and product demand, competition, raw-material costs, foreign sourcing, and environmental remediation. The company expensed $290,000 for monitoring and remediation of a New York landfill issue; a separate Illinois remediation system was estimated at approximately $50,000.
Important facts for investors to verify
- How Velvac’s sales, margins, integration costs, and Road-iQ performance develop, and whether earnout payments become due.
- Whether the acquired business and other segments generate enough cash to service the substantially higher debt and meet covenant thresholds.
- Whether working-capital growth, including inventory and receivables, converts to cash; receivables days rose to 56 from 49 at year-end 2016.
- Whether the expected $3.0 million capital-spending plan and environmental remediation costs change, and whether raw-material costs can be recovered through pricing.
- The company reported $12.6 million of cash held by a foreign subsidiary and stated it intended to reinvest foreign earnings abroad indefinitely; verify accessibility and potential tax implications.