Management's Discussion of Results of Operations (Excerpts)
For purposes of readability, Zenith attempts to strip out all tables in excerpts from the Management Discussion. That information is contained elsewhere in our articles. The idea of this summary is simply to review how well we believe Management does its reporting. Also, this highlights what Management believes is important.
In our Decision Matrix at the end of each article, a company with 0 to 2 gets a "-1", and 3 to 5 gets a "+1."
On a scale of 0 to 5, 5 being best, Zenith rates this company's Management's Discussion as a 5.
We produce custom assemblies pursuant to long-term contracts and customer purchase orders. Backlog consists of aggregate values under such contracts and purchase orders, excluding the portion previously included in operating revenues on the basis of percentage of completion accounting, and including estimates of future contract price escalation. Substantially all of our backlog is subject to termination at will and rescheduling, without significant penalty. Funds are often appropriated for programs or contracts on a yearly or quarterly basis, even though the contract may call for performance that is expected to take a number of years. Therefore, our funded backlog does not include the full value of our contracts. Approximately 80% of the total amount of our backlog at June 30, 2017 was attributable to government contracts. Our unfunded backlog is primarily comprised of the long-term contracts for the G650, E-2D, F-16, T-38, F-35, HondaJet Light Business Jet, Bell AH-1Z, Cessna Citation X+, Sikorsky S-92 and Embraer Phenom 300. These long-term contracts are expected to have yearly orders, which will be funded in the future. The low level of funded backlog on commercial programs is the result of customers placing funded orders based upon expected lead time. These programs are under long-term agreements with our customers, and as such, we are protected by termination liability provisions. Critical Accounting Policies Revenue Recognition We recognize revenue from our contracts over the contractual period under the percentage-of-completion (“POC”) method of accounting. Under the POC method of accounting, sales and gross profit are recognized as work is performed based on the relationship between actual costs incurred and total estimated costs at the completion of the contract. Recognized revenues that will not be billed under the terms of the contract until a later date are recorded as an asset captioned “Costs and estimated earnings in excess of billings on uncompleted contracts.” Contracts where billings to date have exceeded recognized revenues are recorded as a liability captioned “Billings in excess of costs and estimated earnings on uncompleted contracts.” Changes to the original estimates may be required during the life of the contract. Estimates are reviewed monthly and the effect of any change in the estimated gross margin percentage for a contract is reflected in cost of sales in the period the change becomes known. The use of the POC method of accounting involves considerable use of estimates in determining revenues, costs and profits and in assigning the amounts to accounting periods. As a result, there can be a significant disparity between earnings (both for accounting and tax purposes) as reported and actual cash received by us during any reporting period. We continually evaluate all of the issues related to the assumptions, risks and uncertainties inherent with the application of the POC method of accounting; however, we cannot assure you that our estimates will be accurate. If our estimates are not accurate or a contract is terminated, we will be forced to adjust revenue in later periods. Furthermore, even if our estimates are accurate, we may have a shortfall in our cash flow and we may need to borrow money, or seek access to other forms of liquidity, to fund our work in process or to pay taxes until the reported earnings materialize as actual cash receipts. When adjustments are required for the estimated total revenue on a contract, these changes are recognized with an inception-to-date effect in the current period. Also, when estimates of total costs to be incurred exceed estimates of total revenue to be earned, a provision for the entire loss on the contract is recorded in the period in which the loss is determined. Results of Operations Revenue Revenue for the three months ended June 30, 2017 was $16,731,951 compared to $22,280,964 for the same period last year, a decrease of $5,549,013 or 24.9%. This decrease is predominantly the result of a normal cyclical decrease in revenue on the Company’s E-2D program. Revenue for the six months ended June 30, 2017 was $36,764,652 compared to $34,950,997 for the same period last year, an increase of $1,813,655 or 5.2%. During the three months ended March 31, 2016, the Company had information that the United States Air Force (“USAF”) was intending to increase the number of ship sets on order for the A-10. An increase in the number of ship sets on order would improve the Company’s estimated gross margin on the overall program. In April 2016, the Company became aware that the USAF had reevaluated its position and, as such, had deferred any decision regarding increasing the orders on the A-10 program. These changes in position by the USAF were supported by communications from Boeing, the Company’s customer. Based on the above facts, the Company believed that it was not probable that there would be any future orders on the A-10 beyond the 173 currently on order. As a result of the information that management became aware of in April 2016, for the quarter ended March 31, 2016, the Company estimated that the A-10 program would run through the conclusion of its current purchase order with Boeing at ship set number 173. The change in estimate resulted in a reduction of revenue of approximately $8.9 million in the quarter ended March 31, 2016. In addition to the change in estimate adjustment to revenue in the quarter ended March 31, 2016, which caused military revenue to be unusually low in that year, military revenue in 2017 increased by approximately $8.0 million. Revenue from commercial subcontracts was $14,106,590 for the six months ended June 30, 2017 compared to $20,524,578 for the six months ended June 30, 2016, a decrease of $6,417,988 or 31.3%. The decrease in revenue is the result of an approximate $3.3 million decrease in revenue on our Embraer Phenom 300 program, as production rates have declined and a $1.8 million decrease in revenue on our G650 program. Inflation historically has not had a material effect on our operations. Cost of sales Cost of sales for the three months ended June 30, 2017 and 2016 was $13,048,203 and $17,246,963, respectively, a decrease of $4,198,760 or 24.3%, This decrease is the result of the comparable decline in revenue. Cost of sales for the six months ended June 30, 2017 and 2016 was $28,543,390 and $41,556,100, respectively, a decrease of $13,012,710 or 31.3%. The provision for contract losses, as well as lower rate production on our E-2D, Phenom 300 and Embraer programs, all described above have resulted in lower cost of sales. Other contract costs (credit) for the six months ended June 30, 2017 was ($734,997) compared to $3,004,444, a decrease of $3,739,441. Other contract costs (credit) for the three months ended June 30, 2017 was ($262,492) compared to ($1,526,323), an decrease of $1,263,831 or 82.8%. Other contract costs relate to expenses recognized for changes in estimates and expenses predominately associated with loss contracts. Other contract costs are comprised predominantly of charges related to the change in estimate on the A-10 program in 2016. In the six months ended June 30, 2017, other contract costs are a credit, as we have incurred actual expenses on our A-10 program that had been previously recognized as part of the change in estimate charge. Procurement for the six months ended June 30, 2017 was $17,904,113 compared to $26,232,905, a decrease of $8,328,792 or 31.7%. Procurement for the three months ended June 30, 2017 was $8,064,051 compared to $12,930,373, a decrease of $4,866,322 or 37.6%. This decrease is a result of a $3.4 million decrease in procurement on our E-2D program, as we are shipping parts from stock and lowering inventory on this program, as well as an approximately $4.9 million decrease in procurement on the commercial programs described above. Labor costs for the six months ended June 30, 2017 was $3,586,568 compared to $4,330,410, a decrease of $743,842 or 17.2%. The decrease is the result of approximately $224,000 decrease in the commercial programs described above, as well as $519,000 decrease in military programs. Labor costs for the three months ended June 30, 2017 was $1,712,025 compared to $2,035,949, a decrease of $323,924 or 15.9%. Factory overhead for the six months ended June 30, 2017 was $7,787,706 compared to $7,988,341, a decrease of $200,635 or 2.5%. Factory overhead for the three months ended June 30, 2017 was $3,534,619 compared to $3,806,964, a decrease of $272,345 or 7.2%. Gross Profit (Loss) Gross profit (loss) for the six months ended June 30, 2017 was a profit of $8,221,262 compared to a loss of $6,605,103 for the six months ended June 30, 2016, an increase of $14,826,365, predominately the result of the change in estimate on the A-10 program. Gross profit for the three months ended June 30, 2017 was $3,683,748 compared to $5,034,001 for the three months ended June 30, 2016, a decrease of $1,350,253 predominately the result of lower volume, as described above. Favorable/Unfavorable Adjustments to Gross Profit (Loss) During the six months ended June 30, 2017 and 2016, circumstances required that we make changes in estimates to various contracts. During the six months ended June 30, 2017, we had two contracts which had an approximately $659,000 and $436,000 of unfavorable adjustments caused by changing estimates on a long-term program, that we are working with the customer to agree to contract extensions and expect to have to decrease our selling price. Additionally, we had one contract that had a gap in production, as well as a smaller than expected order quantity. The gap in production and low quantity has resulted in an unfavorable adjustment of approximately $475,000. There were no other material changes favorable or unfavorable during the six months ended June 30, 2017. During the six months ended June 30, 2016 we had one contract which had an approximately $270,000 unfavorable adjustment caused by excess labor and procurement costs due to difficulty in the manufacturing process. In addition, we had an approximate $159,000 unfavorable adjustment on one contract that was canceled by the government. Also, we had four contracts that each had between $139,000 and $188,000 (cumulatively $654,000) of unfavorable adjustments caused by excess labor costs incurred. In addition to the above mentioned unfavorable adjustments, in 2016 we had the unfavorable adjustment of approximately, $12.2 million related to the A-10 program described previously. Selling, General and Administrative Expenses Selling, general and administrative expenses for the three months ended June 30, 2017 were $2,002,198 compared to $1,868,787 for the three months ended June 30, 2016, an increase of $133,411, or 7.1%. This change was predominately the result of a decrease of approximately $86,000 in bank fees offset by an increase of $76,000 in marketing, an increase of $75,000 in accrued bonuses and an increase of $73,000 in salaries. Selling, general and administrative expenses for the six months ended June 30, 2017 were $4,166,076 compared to $4,589,170 for the six months ended June 30, 2016, a decrease of $423,094 or 9.2%. This decrease was predominately the result of an approximately $395,000 decrease in loss on unrealized receivables, an approximately $300,000 decrease in professional fees because of the extended audit CPI had in 2016, offset by an increase in salaries of $173,000 and an increase in accrued bonuses of $150,000. Income (Loss) Before Provision for (Benefit from) Income Taxes Income before provision for income taxes for the three months ended June 30, 2017 was $1,215,647 compared to $2,841,580 for the same period last year, a decrease of $1,625,933. Income before provision for income taxes for the six months ended June 30, 2017 was $3,198,948 compared to loss before benefit from income taxes of $11,793,640 for the same period last year, an increase of $14,992,588, predominately the result of the change in estimate on the A-10 program. Provision for (Benefit from) Income Taxes Provision for income taxes was $450,000 and $1,184,000 for the three and six months ended June 30, 2017, compared to provision for income taxes of $1,051,000 for the three months ended June 30, 2016 and benefit from income taxes of $4,364,000 for the six months ended June 30, 2016. The effective tax rate at June 30, 2017 was 37%. The benefit from income taxes recognized in the six months ending March 31, 2016, resulted in the booking of a deferred tax asset. At December 31, 2016, the Company had net operating loss carryforwards of approximately $14.6 million which will expire in 2031. Our historical tax rates have been below the federal statutory rate because of the effect of permanent differences between book and tax deductions, predominately the R&D tax credit and the domestic production activity deduction. Net Income (Loss) Net income for the three months ended June 30, 2017 was $765,647 or $0.09 per basic share, compared to $1,790,580 or $0.21 per basic share, for the same period last year. Net income for the six months ended June 30, 2017 was $2,014,948 or $0.23 per basic share, compared to a loss of $7,429,640 or $0.86 per basic share for the same period last year. Diluted income per share was $0.09 for the three months ended June 30, 2017 calculated utilizing 8,865,055 weighted average shares outstanding. Diluted income per share for the six months ended June 30, 2017 was $0.23, calculated utilizing 8,840,309 average shares outstanding as adjusted for the dilutive effect of outstanding stock options and RSUs. Diluted income per share for the three months ended June 30, 2016 was $0.21, calculated utilizing 8,637,393 average shares outstanding as adjusted for the dilutive effect of outstanding stock options and RSUs. Basic and diluted income per share for the six months ended June 30, 2016 were the same as effects of outstanding options would be anti-dilutive. Liquidity and Capital Resources General At June 30, 2017, we had working capital of $73,799,885 compared to $70,595,485 at December 31, 2016, an increase of $3,204,400 or 4.5%. Cash Flow A large portion of our cash flow is used to pay for materials and processing costs associated with contracts that are in process and which do not provide for progress payments. Costs for which we are not able to bill on a progress basis are components of “Costs and estimated earnings in excess of billings on uncompleted contracts” on our condensed balance sheets and represent the aggregate costs and related earnings for uncompleted contracts for which the customer has not yet been billed. These costs and earnings are recovered upon shipment of products and presentation of billings in accordance with contract terms. Because the POC method of accounting requires us to use estimates in determining revenue, costs and profits and in assigning the amounts to accounting periods, there can be a significant disparity between earnings (both for accounting and tax purposes) as reported and actual cash that we receive during any reporting period. Accordingly, it is possible that we may have a shortfall in our cash flow and may need to borrow money, or to raise additional capital, until the reported earnings materialize into actual cash receipts. At June 30, 2017, we had a cash balance of $1,115,297 compared to $1,039,586 at December 31, 2016. Our costs and estimated earnings in excess of billings increased by $2,113,884 million during the six months ended June 30, 2017. Several of our programs require us to expend up-front costs that may have to be amortized over a portion of production units. In the case of significant program delays and/or program cancellations, we could be required to bear impairment charges which may be material, for costs that are not recoverable. Such charges and the loss of up-front costs could have a material impact on our liquidity. We continue to work to obtain better payment terms with our customers, including accelerated progress payment arrangements, as well as exploring alternative funding sources. We believe that our existing resources, together with the availability under our credit facility, will be sufficient to meet our current working capital needs for at least 12 months from the date of the filing of this Quarterly report on Form 10-Q. Credit Facilities Credit Agreement and Term Loan On March 24, 2016, the Company entered into a Credit Agreement with Bank United, N.A. as the sole arranger, administrative agent and collateral agent and Citzens Bank, N.A. (the “BankUnited Facility”). The BankUnited Facility provides for a revolving credit loan commitment of $30 million (the “Revolving Loan”) and a $10 million term loan (“Term Loan”). The proceeds of the BankUnited Facility were used to pay off all amounts outstanding under the Santander Term Loan and the Revolving Facility. The Revolving Loan bears interest at a rate based upon a pricing grid, as defined in the agreement. As of March 31, 2016, the Company was not in compliance with the net profit, Debt Service Coverage, and Leverage Coverage Ratio financial covenants contained in the BankUnited Facility, which non-compliance was waived (the “Wavier”) by the banks. On May 9, 2016 the Company entered into an amendment (the “Amendment”) to the BankUnited Facility which, among other things, provided for the Waiver. In addition, the Amendment changes the definition of EBITDA for the Leverage Coverage Ratio Covenant for the remainder of 2016 and changes the maximum leverage ratio from 3 to 1 to 3.5 to 1 for the quarters ending June 30, 2016 and September 30, 2016. Also, the Amendment increased the interest rate on the BankUnited Facility by 50 basis points and requires the repayment of a portion of the Term Loan if and to the extent that the Company receives any contract reimbursement payments from its current REA with Boeing on the A-10 program. The Company was in compliance with all of the financial covenants contained in the bank agreement as of June 30, 2017. As of June 30, 2017, the Company had $24.2 million outstanding under the Revolving Loan bearing interest at 4.75%. The BankUnited Revolving Facility is secured by all of our assets. The Term Loan had an initial amount of $10 million, payable in monthly installments, as defined in the agreement, which matures on March 31, 2019. The maturities of the Term Loan are included in the maturities of long-term debt. On March 9, 2012, the Company obtained a $4.5 million term loan from Santander to be amortized over five years (the “Santander Term Facility”). Santander Term Facility was used to purchase tooling and equipment for new programs. Additionally, the Company and Santander Bank entered into a five-year interest rate swap agreement, in the notional amount of $4.5 million. Under the interest rate swap, the Company paid an amount to Santander Bank representing interest on the notional amount at a fixed rate of 4.11% and received an amount from Santander Bank representing interest on the notional amount of a rate equal to the one-month LIBOR plus 3%. The effect of this interest rate swap was the Company paying a fixed interest rate of 4.11% over the term of the Santander Term Facility. The Santander interest swap agreement was terminated and the Santander Term Facility paid off on March 24, 2016 using the proceeds of the BankUnited Facility. In May 2016, the Company entered into a new interest rate swap with the objective of reducing its exposure to cash flow volatility arising from interest rate fluctuations associated with certain debt. The notional amount, maturity date, and currency of this contract match those of the underlying debt. The Company has designated this interest rate swap contract as a cash flow hedge.